Deloitte's Roadmap: Derivatives
Preface
Preface
We are pleased to present the inaugural edition of
Derivatives. This Roadmap provides a comprehensive discussion of the
guidance in ASC 8151 on the identification, classification, measurement, and presentation and
disclosure of derivative instruments, including embedded derivatives.
Accounting for derivatives in accordance with ASC 815 is one of the
most complex areas of U.S. GAAP, primarily because of the nuances involved in
evaluating whether an instrument meets the definition of a derivative and whether a
scope exception is available. The identification of possible embedded derivatives in
a host contract also requires careful evaluation. This Roadmap is intended to help
entities navigate the applicable accounting and financial reporting guidance and
arrive at supportable accounting conclusions. It is assumed in this Roadmap that an
entity has adopted ASU 2016-02 (on leases), ASU 2017-12 (on targeted improvements to
accounting for hedging activities), ASU 2018-12 (on targeted improvements to
accounting for long-duration contracts), and ASU 2020-06 (on an issuer’s accounting
for convertible debt); however, these ASUs do not have a significant impact on the
guidance discussed in this publication.
Please note that hedge accounting is not addressed in this Roadmap.
For a comprehensive discussion of that topic, see Deloitte’s Roadmap Hedge Accounting.
Be sure to check out On the
Radar (also available as a stand-alone
publication), which briefly summarizes
emerging issues and trends related to the accounting and
financial reporting topics addressed in the Roadmap.
We hope you find this Roadmap a useful resource, and we
welcome your suggestions for future improvements. If you need
assistance with applying the guidance or have other questions about this topic, we
encourage you to consult our technical specialists and other professional
advisers.
Footnotes
1
For a list of abbreviations used in this publication, see
Appendix B.
For the full titles of standards, topics, and regulations used in this
publication, see Appendix
A.
On the Radar
On the Radar
Although the guidance on accounting for derivatives has not changed significantly in
recent years, derivative accounting continues to be one of the most complex areas of
U.S. GAAP. ASC 815 prescribes the guidance on instruments and contracts that meet
the definition of a derivative. Some instruments and contracts that meet this
definition are eligible for a scope exception, while others that do not meet the
definition of a derivative in their entirety must still be evaluated to determine
whether they contain embedded derivatives that would be within the scope of ASC 815.
In addition, some derivatives are designated in a qualified hedging relationship and
eligible for specialized hedge accounting (see Deloitte’s Roadmap Hedge Accounting for further information on
this topic).
Financial Reporting Considerations
In the simplest terms, a derivative is an instrument whose value depends on (or
is derived from) the value of an underlying variable or variables, such as the
prices of traded assets. Most derivatives are net-settled contracts that allow
the holder to benefit from changes in the value of a referenced asset or other
market variable while making a smaller initial investment than would be required
to own that asset and experience similar gains and losses.
There are different types of derivative contracts, but the most common ones are
forwards, futures, options, and swaps. When an entity enters into these types of
contracts, it may be fairly obvious that such a contract meets the definition of
a derivative. However, the accounting definition of a derivative sometimes
encompasses other types of contracts that are not commonly thought of as
derivatives, such as financial guarantees and contracts to purchase materials or
power, or commodity contracts that require the physical delivery of assets that
are readily convertible to cash.
In accordance with ASC 815-10-15-83, all three of the criteria below must
be satisfied for a contract to meet the definition of a derivative:
An entity should apply the guidance in ASC 815 when determining whether a
specific contract meets the definition of a derivative. See Chapter 1 for further information.
In addition to providing the criteria required for a contract to be considered a
derivative, ASC 815-10 includes a variety of scope exceptions. A contract that
would otherwise meet the definition of a derivative may qualify for one of those
exceptions, in which case it would be accounted for on the basis of other
applicable U.S. GAAP. Some of the more frequently used scope exceptions apply to
(1) certain contracts involving an entity’s own equity and (2) certain contracts
that are consistent with an entity’s normal course of business (the normal
purchases and normal sales scope exception). These scope exceptions, and many
others, are explained in more detail in Chapter
2.
A contract that would otherwise meet the definition of
a derivative in ASC 815 but qualifies for a scope
exception does not require classification and
measurement as a derivative asset or liability. An
entity should consider whether a contract meets any
of the available scope exceptions before applying
the guidance in ASC 815 on classification,
recognition, and measurement of derivatives.
An instrument that does not meet the definition of a derivative in its entirety
may contain contractual terms or features that affect the cash flows, values, or
other exchanges required by the terms of the instrument in a manner similar to a
derivative. Such terms or features are “embedded” in the overall arrangement or
contract and are referred to as “embedded derivatives.”
Under ASC 815-15-25-1, an entity is required to bifurcate and
separately account for a feature embedded within another contract (the host
contract) if all three of the conditions shown below are met.
Embedded derivatives are commonly identified in debt and equity instruments,
although it is possible for them to exist in other contracts (e.g., leases,
service arrangements, insurance contracts). For example, if options allow the
holder of a debt or equity instrument to either convert its instrument into
shares of the issuer’s equity or redeem its instrument for cash, such options
are embedded derivatives in the debt or equity instrument, respectively.
The determination of whether an embedded feature in a debt or
equity host meets the definition of a derivative often depends on whether one of
the criteria related to net settlement is met. For instance, equity in an entity
that is not publicly traded is generally not readily convertible to cash, so
redemption or conversion options for a nonpublic entity would generally not meet
the definition of a derivative. When assessing whether an embedded feature, if
freestanding, would meet the definition of a derivative, an entity should
closely evaluate whether the feature provides for net settlement.
See Chapter 4 for further information on
features embedded in a contract that may require bifurcation.
If an entity determines that one of the criteria for
bifurcation of an embedded derivative is not met,
the embedded feature does not need to be bifurcated
and further analysis of the remaining criteria is
not necessary.
A key underlying principle of ASC 815 is that derivatives represent either assets
or liabilities in the statement of financial position, and those assets or
liabilities should be measured initially and subsequently at fair value by
applying the concepts of ASC 820 (see Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the
Fair Value Option) for more guidance). The accounting for
changes in the fair of a derivative instrument depends on whether it has been
designated as a hedging instrument in a qualified hedging relationship.
Derivatives that are designated as a hedging instrument in a qualified hedging
relationship are eligible for specialized hedge accounting (see Deloitte’s
Roadmap Hedge Accounting for more
information). Other than in limited scenarios, the gain or loss on a derivative
instrument that has not been designated as a hedging instrument should be
recognized in current-period earnings. See Chapter
3 for further details on the measurement and recognition of
derivatives that have not been designated as a hedging instrument.
In addition, if any feature of an instrument has been identified and bifurcated
as an embedded derivative, the entity should apply the accounting in ASC 815
related to measurement and recognition as if that embedded derivative were a
freestanding derivative. Therefore, such an embedded derivative should be
initially recorded at fair value and remeasured to its fair value in each
reporting period. Unless the bifurcated embedded derivative is designated in a
qualified hedging relationship, changes in the derivative’s fair value are
recognized through earnings in each reporting period.
Standard-Setting Activity
Definition of a Derivative — FASB Research Project
As of the date of this Roadmap, the FASB’s research agenda includes a
project on the definition of a derivative. The
objective of the research project is to consider possible refinements to the
scope of ASC 815, including potential application guidance specific to
certain arrangements such as research and development funding arrangements
and sustainability-linked financial instruments (see below). Entities should
monitor this research project with their accounting advisers for any new
developments.
Sustainability-Linked Debt Instruments
Entities that seek to demonstrate their corporate
social responsibility may issue debt instruments
whose payment terms vary depending on specified
environmental factors (sometimes also referred to as
sustainability factors). The inclusion of such
features in debt instruments has become more common
over the past several years as investors, credit
rating agencies, lenders, regulators, policy makers,
and other interested parties have increasingly
focused on environmental, social, and governance
(ESG) matters. Holders and issuers of
sustainability-linked debt instruments must evaluate
whether such arrangements contain an embedded
feature or features that must be separately
accounted for as a derivative under ASC 815-15.
Given the wide variety of environmentally linked
terms and the evolving nature of these instruments,
entities are strongly encouraged to discuss their
accounting analyses with their advisers.
Updates to Accounting for Convertible Instruments and Contracts on an Entity’s Own Equity — ASU 2020-06
In August 2020, the FASB issued ASU 2020-06,
which simplifies the accounting for certain financial instruments with
characteristics of liabilities and equity, including convertible instruments
and contracts on an entity’s own equity. In addition, ASU 2020-06 removes
some of the required conditions for equity classification. Contracts on an
entity’s own equity that do not qualify as equity under ASC 815-40 must be
accounted for at fair value, with changes in fair value recognized in
earnings, irrespective of whether such contracts meet the definition of a
derivative in ASC 815. For further details, see Deloitte’s August 5, 2020,
Heads Up.
This Roadmap provides a comprehensive discussion of
the identification, classification, measurement, and
presentation and disclosure of derivative
instruments, including embedded derivatives. For
further guidance on the application of hedge
accounting to a qualified hedging relationship, see
Deloitte’s Roadmap Hedge Accounting.
Contacts
Contacts
|
Jonathan Howard
Partner
Deloitte & Touche
LLP
+1 203 761 3235
|
|
Ashley Carpenter
Partner
Deloitte & Touche
LLP
+1 203 761 3197
|
|
Jamie Davis
Partner
Deloitte & Touche
LLP
+1 312 486 0303
|
For information about Deloitte’s
derivatives accounting service offerings, please contact:
|
Andrew Pidgeon
Partner
Deloitte & Touche
LLP
+1 415 783 6426
|
Chapter 1 — Introduction
Chapter 1 — Introduction
1.1 Overview
ASC 815 is the source of authoritative literature in U.S. GAAP on derivatives and hedging. The main principles of ASC 815 were derived from FASB Statement 133, which established comprehensive accounting and reporting requirements for derivatives (as defined in the standard) and qualifying hedging activities. Shortly after the issuance of Statement 133 in June 1998, the FASB established a
Derivatives Implementation Group (DIG) to provide interpretive guidance, which
became authoritative once formally cleared by the FASB. The FASB issued more than
130 DIG Issues (excluding transition issues). When the FASB Accounting Standards
Codification (the “Codification”) was released in 2009, ASC 815 became the
primary home of the collective guidance.
ASC 815-10
05-1 The
Derivatives and Hedging Topic includes the following
Subtopics:
- Overall
- Embedded Derivatives
- Hedging — General
- Fair Value Hedges
- Cash Flow Hedges
- Net Investment Hedges
- Contracts in Entity’s Own Equity
- Weather Derivatives.
05-2 The first
six Subtopics address the accounting for derivative
instruments, including certain derivative instruments
embedded in other contracts, and hedging activities. The
last two Subtopics provide guidance on accounting for
contracts that have characteristics of derivative
instruments but that are not accounted for as derivative
instruments under this Subtopic.
05-4 This Topic
requires that an entity recognize derivative instruments,
including certain derivative instruments embedded in other
contracts, as assets or liabilities in the statement of
financial position and measure them at fair value. If
certain conditions are met, an entity may elect, under this
Topic, to designate a derivative instrument in any one of
the following ways:
- A hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk (referred to as a fair value hedge)
- A hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk (referred to as a cash flow hedge)
- A hedge of the foreign currency
exposure of any one of the following:
- An unrecognized firm commitment (a foreign currency fair value hedge)
- An available-for-sale debt security (a foreign currency fair value hedge)
- A forecasted transaction (a foreign currency cash flow hedge)
- A net investment in a foreign operation.
10-1 Four
fundamental decisions serve as cornerstones underlying the
guidance in this Topic:
- Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.
- Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments. Derivative instruments should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (that is, gains or losses) that are attributable to the risk being hedged and that arise while the hedge is in effect.
- Only items that are assets or liabilities should be reported as such in financial statements.
- Special accounting for items designated as being hedged should be provided only for qualifying items. One aspect of qualification should be an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged.
ASC 815 establishes the accounting and reporting standards for
derivative instruments, including certain derivatives embedded in other contracts,
and hedging activities.1 A foundational principle of ASC 815 is that an entity should recognize
derivatives as either assets or liabilities in the statement of financial position
and measure those instruments at fair value. Fair value is the most relevant measure
for derivative contracts.
If certain conditions are met, ASC 815 allows an entity to designate
a derivative in a specialized hedge accounting relationship. The accounting for
changes in a derivative’s fair value (i.e., gains and losses) depends on the
intended use of the derivative and the resulting designation.2 For a derivative that is not designated as a hedging instrument, the gain or
loss is recognized in earnings in the period of change unless the derivative
qualifies for a scope exception under ASC 815.
Footnotes
1
See Deloitte’s Roadmaps Hedge Accounting and Contracts on an Entity’s Own
Equity for authoritative and interpretive guidance on
these topics. The guidance within this Roadmap is related to other ASC 815
matters.
2
See Deloitte’s Roadmap Hedge Accounting for more
information about the different types of hedging arrangements and the
resulting accounting consequences.
1.2 Types of Derivatives
The four major types of derivative contracts are as follows:
-
Forwards — A forward contract, which is a relatively simple derivative, is an agreement to buy or sell an asset on a future date for an agreed-upon price. It differs from a spot contract, which is an agreement to buy or sell an asset immediately. A forward contract is traded in the over-the-counter (i.e., noncentralized) market. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a specified future date for an agreed-upon price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Typically, it costs nothing to enter into a forward contract (i.e., it has a zero fair value on the date the counterparties enter into the contract).
-
Futures — A futures contract is similar to a forward contract in that it is an agreement between two parties to buy or sell an asset on a future date for an agreed-upon price. However, unlike forward contracts, futures contracts are normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract. Since the two parties to the contract do not necessarily know each other, the exchange also provides a mechanism that gives the two parties a guarantee that the contract will be honored.
-
Options — An option gives the holder the right to either buy or sell the underlying asset, depending on the nature of the option, by a future date for an agreed-upon price. However, unlike parties to forwards and futures, an option holder is not obligated to buy or sell the underlying asset. In addition, whereas it typically costs nothing to enter into a forward or futures contract, there is a cost to acquiring an option (called the premium).Options are traded both on exchanges and in the over-the-counter market. There are two types of options:
-
A call option gives the holder the right to buy the underlying asset by a certain date for an agreed-upon price.
-
A put option gives the holder the right to sell the underlying asset by a certain date for an agreed-upon price.
For both types of options, the greater the amount of time until maturity, the more valuable they tend to be. An option contract specifies (1) the price at which the holder can exercise the option, known as the strike price or exercise price, and (2) the date the option expires, known as the expiration date or maturity date. American options can be exercised at any time up to the expiration date, while European options can be exercised only on the expiration date. Bermudan options are a restricted form of the American option that allows for early exercise but only on specified dates during the life of the option. -
-
Swaps — A swap is an agreement between two parties to exchange cash flows in the future. The agreement specifies the dates on which the cash flows are to be paid and the way in which they will be calculated. The most common type of swaps are interest rate swaps and currency swaps:
-
In an interest rate swap, one party agrees to pay to a second party cash flows equal to the interest on a notional principal, calculated at a specified fixed rate for a predetermined period. In return, the first party receives interest at a floating rate on the same notional principal for the same period from the other party.
-
In a currency swap, parties exchange principal and interest payments at a fixed or variable rate in one currency for principal and interest payments at a fixed or variable rate, respectively, in another currency. The agreement requires the principal to be specified in each of the two currencies. The principal amounts are usually exchanged at the beginning and end of the life of the swap. Usually, the principal amounts are calculated to be approximately equivalent on the basis of the spot exchange rate at the swap’s initiation.
-
1.3 Concept of Embedded Derivatives
ASC 815-15
05-1 Contracts that do not in
their entirety meet the definition of a derivative
instrument (see paragraphs 815-10-15-83 through 15-139),
such as bonds, insurance policies, and leases, may contain
embedded derivatives. The effect of embedding a derivative
instrument in another type of contract (the host contract)
is that some or all of the cash flows or other exchanges
that otherwise would be required by the host contract,
whether unconditional or contingent on the occurrence of a
specified event, will be modified based on one or more
underlyings.
15-2
The guidance in this Subtopic applies only to contracts that
do not meet the definition of a derivative instrument in
their entirety.
A contract that itself does not meet the definition of a derivative in its entirety
may have implicit or explicit terms that affect the cash flows or the value of the
contract in a manner similar to a derivative. Those implicit or explicit terms may
qualify as “embedded derivatives” under the guidance in ASC 815-15. A contract in
which the derivative is embedded is referred to as the “host contract”; when
combined, the host contract and the embedded derivative are referred to as a “hybrid
instrument.”
An embedded feature will only require separate accounting treatment
as a derivative if it meets the following three conditions in ASC 815-15-25-1:
-
The embedded derivative is “not clearly and closely related” to the host contract (see Section 4.3.2).
-
The instrument is not subject to recurring fair value measurement, with changes in fair value recorded through earnings (see Section 4.3.3).
-
The embedded derivative would meet the definition of a derivative within the scope of ASC 815 if it were issued on a freestanding (stand-alone) basis (see Section 1.4).
In developing the derivative accounting requirements that are now located in ASC 815
(such as the requirement to measure derivatives at fair value on a recurring basis),
the FASB concluded that an entity should not be able to circumvent those
requirements by incorporating derivatives into the contractual terms of
nonderivative contracts (e.g., outstanding debt or equity). Accordingly, it decided
that when certain criteria are met (described above), derivatives embedded in the
terms of nonderivative contracts should be accounted for as derivatives separately
from the contracts in which they are embedded. An entity is thus unable to avoid the
recognition and measurement requirements of ASC 815 merely by embedding a derivative
instrument in a nonderivative financial instrument or another contract.
1.4 Definition of a Derivative
Derivatives are instruments whose value depends on (or is derived
from) the value of underlying variables, such as the prices of traded assets. A
stock option, for example, is a derivative whose value depends on the price of the
underlying stock. However, derivatives can be dependent on almost any variable, from
the price of corn to the amount of snowfall during a period.
In essence, most derivatives are net-settled contracts that allow the holder to
benefit from changes in the value of either a referenced asset or another market
variable (while making a smaller initial investment than would be required to own
that asset and experience similar gains and losses). A contract that allows a party
to receive or make a payment on the basis of a specified event or condition may also
represent a derivative (see discussion on payment provisions below). Although it may
be fairly obvious that certain contracts such as swaps, options, futures, or
warrants typically meet the accounting definition of a derivative, that definition
sometimes encompasses other types of contracts that are not commonly thought of as
derivatives, such as financial guarantees, contracts to purchase materials or power,
or commodity contracts that require the physical delivery of assets that are readily
convertible to cash (RCC).
However, for a contract to require derivative accounting, it (1) must meet all of the
criteria in the definition of a derivative instrument in ASC 815-10-15-83 and (2)
cannot qualify for any of the ASC 815-10 scope exceptions (see Chapter 2).
ASC 815-10
15-83
A derivative instrument is a financial instrument or other
contract with all of the following characteristics:
- Underlying, notional amount, payment provision. The
contract has both of the following terms, which
determine the amount of the settlement or
settlements, and, in some cases, whether or not a
settlement is required:
- One or more underlyings
- One or more notional amounts or payment provisions or both.
- Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Net settlement. The contract can be settled net by
any of the following means:
- Its terms implicitly or explicitly require or permit net settlement.
- It can readily be settled net by a means outside the contract.
- It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
ASC 815-10 — Glossary
Financial Instrument
Cash, evidence of an ownership interest in an entity, or a
contract that both:
- Imposes on one entity a contractual obligation
either:
- To deliver cash or another financial instrument to a second entity
- To exchange other financial instruments on potentially unfavorable terms with the second entity.
- Conveys to that second entity a contractual right
either:
- To receive cash or another financial instrument from the first entity
- To exchange other financial instruments on potentially favorable terms with the first entity.
The use of the term financial instrument in this definition
is recursive (because the term financial instrument is
included in it), though it is not circular. The definition
requires a chain of contractual obligations that ends with
the delivery of cash or an ownership interest in an entity.
Any number of obligations to deliver financial instruments
can be links in a chain that qualifies a particular contract
as a financial instrument.
Contractual rights and contractual obligations encompass both
those that are conditioned on the occurrence of a specified
event and those that are not. All contractual rights
(contractual obligations) that are financial instruments
meet the definition of asset (liability) set forth in FASB
Concepts Statement No. 6, Elements of Financial Statements,
although some may not be recognized as assets (liabilities)
in financial statements — that is, they may be
off-balance-sheet — because they fail to meet some other
criterion for recognition.
For some financial instruments, the right is held by or the
obligation is due from (or the obligation is owed to or by)
a group of entities rather than a single entity.
As noted in ASC 815-10-15-83, for a derivative instrument to exist, there must be “a
financial instrument or other contract.” This is consistent with ASC 815-10-10-1(a),
which states that “[d]erivative instruments represent rights or obligations that
meet the definitions of assets or liabilities and should be reported in financial
statements.”
ASC 815 defines a derivative as a financial instrument or other contract with all of
the following characteristics:
-
An underlying and either a notional amount or payment provision, or both (see Section 1.4.1).
-
No or a smaller initial net investment (see Section 1.4.2).
-
Net settlement (see Section 1.4.3).
1.4.1 Underlying, Notional Amount, and Payment Provision
The first characteristic of a derivative in ASC 815-10-15-83 is that it has both
“[o]ne or more underlyings” (see below) and “[o]ne or more notional amounts or
payment provisions or both” (see Section 1.4.1.2).
1.4.1.1 Underlying
ASC 815-10 — Glossary
Underlying
A specified interest rate, security price, commodity
price, foreign exchange rate, index of prices or
rates, or other variable (including the occurrence
or nonoccurrence of a specified event such as a
scheduled payment under a contract). An underlying
may be a price or rate of an asset or liability but
is not the asset or liability itself. An underlying
is a variable that, along with either a notional
amount or a payment provision, determines the
settlement of a derivative instrument.
ASC 815-10
15-88 An underlying is a
variable that, along with either a notional amount
or a payment provision, determines the settlement of
a derivative instrument. An underlying usually is
one or a combination of the following:
- A security price or security price index
- A commodity price or commodity price index
- An interest rate or interest rate index
- A credit rating or credit index
- An exchange rate or exchange rate index
- An insurance index or catastrophe loss index
- A climatic or geological condition (such as temperature, earthquake severity, or rainfall), another physical variable, or a related index
- The occurrence or nonoccurrence of a specified event (such as a scheduled payment under a contract).
15-89 However, an underlying
may be any variable whose changes are observable or
otherwise objectively verifiable. An underlying may
be a price or rate of an asset or liability but is
not the asset or liability itself.
15-90 Reference to either a
notional amount or a payment provision is needed in
relation to an underlying to compute the contract’s
periodic settlements and resulting changes in fair
value.
All derivatives have one or more underlyings. An underlying is a variable
(e.g., a price, rate, index, or the occurrence or nonoccurrence of a
specified event) that could cause the payments or other settlements required
by a contract to change.
In the determination of the contractual cash flows or other exchanges
required by a derivative and of the derivative’s value, the underlying is
applied to a notional amount (e.g., an interest rate might be applied to the
debt’s outstanding amount) or there is a payment provision (e.g., a fixed
payment might be triggered if a specified event occurs).
ASC 815-10
Example 3: Underlying — Determination of an
Underlying if a Commodity Contract Includes Both
Fixed and Variable Price Elements
55-77 The following
Cases illustrate the determination of an underlying if a
commodity contract includes a fixed element and a
variable element:
- A commodity contract between two parties to transact a fixed quantity at a specified future date at a fixed price (such as the commodity’s forward price at the inception of the contract) (Case A)
- A commodity contract between two parties to transact a fixed quantity at a specified future date at whatever the prevailing market price might be at that future date (Case B)
- A commodity contract having features of both a fixed-price contract and variable-price contract; specifically, an agreement to purchase a commodity in the future at the prevailing market index price at that future date plus or minus a fixed basis differential set at the inception of the contract (Case C).
55-78 Assume that
each of the contracts in Cases A, B, and C has the
characteristics of notional amount, underlying, and no
initial net investment and that the commodity to be
delivered is readily convertible to cash as discussed
beginning in paragraph 815-10-15-119.
Case A: Fixed-Price Commodity Contract
55-79 This
fixed-price commodity contract is a derivative
instrument because it meets all the criteria in
paragraph 815-10-15-83, including having an underlying
(namely, the price of the commodity), as required by
paragraph 815-10-15-83(a)(1). The contract’s fair value
will change as the underlying changes because the
contract price is not the prevailing market price at the
future transaction date. A party to this contract would
need to determine if the normal purchases and normal
sales exception (see discussion beginning in paragraph
815-10-15-22) applies to the contract.
Case B: Variable-Price Commodity Contract
55-80 This
variable-price commodity contract is a derivative
instrument because it meets all the criteria in
paragraph 815-10-15-83, including having an underlying
(namely, the price of the commodity), as required by
paragraph 815-10-15-83(a)(1). However, because the
contract price is the prevailing market price at the
future transaction date, the variable-price commodity
contract would not be expected to have a fair value
other than zero. A party to this contract would need to
determine if the normal purchases and normal sales
exception (see discussion beginning in paragraph
815-10-15-22) applies to the contract.
Case C: Mixed-Price Commodity Contract
55-81 In a
commodity contract between a buyer and seller of crude
oil, the buyer is a refinery that seeks to use the crude
oil in the production of unleaded gasoline. The buyer
agrees in January to buy 1,000,000 barrels of a specific
type of crude oil in July from the seller at the July 1
West Texas Intermediate index price plus $1.00 per
barrel. The contract appears to be primarily a
variable-price contract, but includes a fixed margin
above that price. (If the buyer or the seller no longer
wants exposure to fluctuations in the West Texas
Intermediate index between January and July, it will
separately use the futures market to fix the West Texas
Intermediate index portion of the contract.)
55-82 The fixed
$1.00 differential is commonly referred to as the basis
differential, but it reflects multiple factors, such as
timing, quality, and location. If not fixed, the basis
differential can be very volatile, because it captures
the passage of time (a financing element), changes in
relative value of different qualities (or grades) of
crude to each other (light versus heavy, sweet versus
sour), and changes in the attractiveness of locations
from the central pricing hub (Cushing, Oklahoma)
relative to each other factor. Supply and demand is a
critical factor in influencing the changes in basis due
to quality and location; for example, an increase in
imports of light crude through the Gulf of Mexico
corridor will tend to lower the basis differential for
light crude (falling prices due to increased supply) and
tend to direct domestic supplies of light crude to
northern U.S. locations (because the foreign oil fills
southern U.S. demand), lowering the basis differential
for contracts calling for delivery at northern points
(again due to increased supply in the North). The basis
differential therefore is not a simple fixed transport
charge, but rather a complex and volatile variable in
itself. For this reason, energy traders may specialize
solely in trading basis and seeking the most attractive
differential at all times relative to the West Texas
Intermediate index — fixing and unfixing basis by
selling contracts back to counterparties or entering
into offsetting contracts with third parties.
55-83 The whole
mixed-attribute contract is a derivative instrument
because the basis differential is a market variable in
determining the final transaction price under the
contract, and this variable has been fixed in the
contract, producing an underlying. (If the differential
was a market pricing convention that typically would not
be expected to change, the contract would be a
derivative instrument with very minor, if any,
fluctuations in fair value.) The fact that the base
commodity price in the contract is variable will help to
mute the fluctuations in fair value of the contract as a
whole, but there still will be potential changes in fair
value of the overall contract because of the fixed-basis
element. A party to this contract would need to
determine if the normal purchases and normal sales
exception applies to the contract. (Paragraph
815-20-55-47 explains why such a mixed-attribute
contract that is a derivative instrument would generally
not be sufficiently effective if designated as the sole
hedging instrument in a cash flow hedge of the
anticipated purchase or sale of the commodity.)
Example 1-1
Identifying Underlyings in a Litigation Funding
Arrangement
In 20X1, Entity A entered into a
lawsuit regarding certain disputes. In 20X2, it
enters into a litigation funding arrangement with
Entity B, a private investment company that invests
in commercial legal claims it believes are
meritorious. In accordance with the agreement, B
agrees to pay up to $1 million (“Investment”) of A’s
litigation costs to pursue the claims.
In consideration for B’s entering into the agreement,
A assigns to B the rights to a portion of the
settlement proceeds. Upon a defendant’s payment of
any cash proceeds to A, A and B will share them as
follows:
- First, 100 percent of all proceeds will be paid to B until B has received an amount equal to the base return.
- Second, all remaining proceeds (after (1)) will be paid to A.
The computation of the base return will depend on the
length of time since the investment date:
- Less than three months — 1.5 × Investment.
- More than three months but less than or equal to five months — 1.75 × Investment.
- More than five months — 2 × Investment.
If A enters into a merger or other corporate
transaction (i.e., a change in control) and, by
mutual agreement with B and the successor entity,
determines that the litigation should not be pursued
further, B will be entitled to the payment of the
base return from the proceeds of the applicable
(change-in-control) transaction.
The agreement contains the following underlyings:
- Proceeds from litigation — In the absence of a change in control, the payout to B will depend solely on the proceeds received from the litigation.
- The occurrence or nonoccurrence of a change in control — If there is a change in control and litigation is halted, B receives the base return but the payout is funded by the proceeds from the change in control, as opposed to the proceeds from the litigation.
1.4.1.2 Notional Amount or Payment Provision
1.4.1.2.1 Notional Amount
ASC 815-10 — Glossary
Notional Amount
A number of currency units, shares, bushels,
pounds, or other units specified in a derivative
instrument. Sometimes other names are used. For
example, the notional amount is called a face
amount in some contracts.
ASC 815-10
Notional Amount
15-92 A notional amount is a
number of currency units, shares, bushels, pounds,
or other units specified in the contract. Other
names are used, for example, the notional amount
is called a face amount in some contracts. The
settlement of a derivative instrument with a
notional amount is determined by interaction of
that notional amount with the underlying. The
interaction may be simple multiplication, or it
may involve a formula with leverage factors or
other constants. As defined in the glossary, the
effective notional amount is the stated notional
amount adjusted for any leverage factor. If a
requirements contract contains explicit provisions
that support the calculation of a determinable
amount reflecting the buyer’s needs, then that
contract has a notional amount. See paragraphs
815-10-55-5 through 55-7 for related
implementation guidance. For implementation
guidance on identifying a commodity contract’s
notional amount, see paragraph 815-10-55-5.
To meet the definition of a derivative, a contract must
contain a notional amount or a payment provision. A notional amount is a
quantity that interacts with an underlying in the determination of the
cash flows or fair value of the contract. Examples of notional amounts
include monetary quantities (e.g., the principal amount of debt) or a
number of equity shares (e.g., the number of equity shares that would be
received upon conversion of a convertible instrument).
Typically, a commodity contract specifies the number of
units of the commodity to be bought or sold under the contract’s pricing
terms. However, some contracts (referred to as requirements contracts)
do not specify the number of units to be bought or sold but instead just
require the buyer to purchase the number of units that satisfies its
actual needs for the commodity during the period of the contract. Since,
under a requirements contract, the buyer typically depends exclusively
on the seller for all of its commodity needs, it is important that the
seller has an understanding of the buyer’s anticipated volumes. As
indicated in ASC 815, a “notional” amount in a requirements contract can
only exist if that quantity can be reliably determined. As illustrated
in ASC 815-10-55-5 through 55-7, even if the notional amount is not
specified in such contracts, the amount can often be reliably determined
on the basis of other provisions within the contract or contemporaneous
agreements.
ASC 815-10
Notional Amount — Identifying a
Commodity Contract’s Notional Amount
55-5 Many
commodity contracts specify a fixed number of
units of a commodity to be bought or sold under
the pricing terms of the contract (for example, a
fixed price). However, some contracts do not
specify a fixed number of units. For example,
consider the following four contracts that require
one party to buy the following indicated
quantities:
- Contract 1: As many units as required to satisfy its actual needs (that is, to be used or consumed) for the commodity during the period of the contract (a requirements contract). The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).
- Contract 2: Only as many units as needed to satisfy its actual needs up to a maximum of 100 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).
- Contract 3: A minimum of 60 units and as many units needed to satisfy its actual needs in excess of 60 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).
- Contract 4: A minimum of 60 units and as many units needed to satisfy its actual needs in excess of 60 units up to a maximum of 100 units. The party is not permitted to buy more than its actual needs (for example, the party cannot buy excess units for resale).
55-6
Generally, the anticipated number of units covered
by a requirements contract is equal to the buyer’s
needs. When a requirements contract is negotiated
between the seller and buyer, both parties
typically have the same general understanding of
the buyer’s estimated needs. Given the buyer’s
often exclusive reliance on the seller to supply
all its needs of the commodity, it is imperative
from the buyer’s perspective that the supplier be
knowledgeable with respect to anticipated volumes.
In fact, the pricing provisions within
requirements contracts are directly influenced by
the estimated volumes.
55-7 This
guidance focuses solely on whether the contracts
under consideration have a notional amount
pursuant to the definition in this Subtopic. These
types of contracts may not satisfy certain of the
other required criteria in this Subtopic for them
to meet the definition of a derivative instrument.
The conclusion that a requirements contract has a
notional amount as defined in this Subtopic can be
reached only if a reliable means to determine such
a quantity exists. Application of this guidance to
specific contracts is as follows:
- Contract 1 — requirements contract. The identification of a requirements contract’s notional amount may require the consideration of volumes or formulas contained in attachments or appendixes to the contract or other legally binding side agreements. The determination of a requirements contract’s notional amount must be performed over the life of the contract and could result in the fluctuation of the notional amount if, for instance, the default provisions reference a rolling cumulative average of historical usage. If the notional amount is not determinable, making the quantification of such an amount highly subjective and relatively unreliable (for example, if a contract does not contain settlement and default provisions that explicitly reference quantities or provide a formula based on historical usage), such contracts are considered not to contain a notional amount as that term is used in this Subtopic. One technique to quantify and validate the notional amount in a requirements contract is to base the estimated volumes on the contract’s settlement and default provisions. Often the default provisions of requirements contracts will specifically refer to anticipated quantities to utilize in the calculation of penalty amounts in the event of nonperformance. Other default provisions stipulate penalty amounts in the event of nonperformance based on average historical usage quantities of the buyer. If those amounts are determinable, they shall be considered the notional amount of the contract.
- Contract 2 — requirements contract with a specified maximum quantity. Whether the contract has a notional amount depends. The same considerations discussed in (a) with respect to Contract 1 also apply to Contract 2; however, the notional amount cannot exceed 100 units.
- Contract 3 — requirements contract with a specified minimum quantity. The contract has a notional amount. The same considerations discussed in (a) with respect to Contract 1 also apply to Contract 3; however, the notional amount of Contract 3 cannot be less than 60 units. A contract that specifies a minimum number of units always has a notional amount at least equal to the required minimum number of units. Only that portion of the requirements contract with a determinable notional amount would be accounted for as a derivative instrument under this Subtopic.
- Contract 4 — requirements contract with a specified maximum and minimum quantities. The contract has a notional amount. The same considerations discussed in (a) with respect to Contract 1 also apply to Contract 4; however, the notional amount of Contract 4 cannot be less than 60 units or greater than 100 units. A contract that specifies a minimum number of units always has a notional amount at least equal to the required minimum number of units. Only that portion of the requirements contract with a determinable notional amount would be accounted for as a derivative instrument under this Subtopic.
Example 1-2
Identifying the Notional Amount in a
Contract
Company XYZ enters into a contract to provide all
of the aluminum that Company ABC will need in its
manufacturing process. The contract specifies a
fixed price and states that in the event that ABC
does not take delivery of the aluminum from XYZ
but instead purchases it from an unrelated entity,
ABC must pay a penalty based on the change in the
market price of aluminum plus a fixed penalty. The
calculation of the penalties will be based on the
average amount of aluminum used by ABC in its
annual production, which is specified as 100
million tons in the contract.
While the contract between XYZ and ABC does not
specify how much aluminum ABC must purchase, the
contract does identify a notional amount that is
based on ABC’s average use of aluminum, and
therefore the contract has a notional amount equal
to the amount specified in the contract’s penalty
provisions (i.e., 100 million tons).
1.4.1.2.2 Payment Provision
ASC 815-10 — Glossary
Payment Provision
A payment provision specifies a fixed or
determinable settlement to be made if the
underlying behaves in a specified manner.
ASC 815-10
Payment Provision
15-93 As defined in the
glossary, a payment provision specifies a fixed or
determinable settlement to be made if the
underlying behaves in a specified manner. For
example, a derivative instrument might require a
specified payment if a referenced interest rate
increases by 300 basis points.
A payment provision is a fixed or determinable payment that is triggered
by specified changes in the underlying. Examples include the following:
- A contract to pay a fixed amount upon the occurrence or nonoccurrence of an event (e.g., change of control or an event of default).
- A contract to pay a fixed amount if the company’s share price falls below a particular dollar value.
- A contract to pay a fixed amount if the company’s credit rating changes.
1.4.2 Initial Net Investment
ASC 815-10
15-83 A derivative instrument
is a financial instrument or other contract with all of
the following characteristics: . . .
b. Initial net investment. The contract
requires no initial net investment or an initial
net investment that is smaller than would be
required for other types of contracts that would
be expected to have a similar response to changes
in market factors. . . .
15-94 Many derivative
instruments require no initial net investment. Some
require an initial net investment as compensation for
one or both of the following:
- Time value (for example, a premium on an option)
- Terms that are more or less favorable than market conditions (for example, a premium on a forward purchase contract with a price less than the current forward price).
Others require a mutual exchange of currencies or other
assets at inception, in which case the net investment is
the difference in the fair values of the assets
exchanged.
15-95 A derivative instrument
does not require an initial net investment in the
contract that is equal to the notional amount (or the
notional amount plus a premium or minus a discount) or
that is determined by applying the notional amount to
the underlying. For example:
- A commodity futures contract generally requires no net investment, while purchasing the same commodity requires an initial net investment equal to its market price. However, both contracts reflect changes in the price of the commodity in the same way (that is, similar gains or losses will be incurred).
- A swap or forward contract generally does not require an initial net investment unless the terms favor one party over the other.
- An option generally requires that one party make an initial net investment (a premium) because that party has the rights under the contract and the other party has the obligations.
15-96 If the initial net
investment in the contract (after adjustment for the
time value of money) is less, by more than a nominal
amount, than the initial net investment that would be
commensurate with the amount that would be exchanged
either to acquire the asset related to the underlying or
to incur the obligation related to the underlying, the
characteristic in paragraph 815-10-15-83(b) is met. The
amount of that asset acquired or liability incurred
should be comparable to the effective notional amount of
the contract. This does not imply that a slightly
off-market contract cannot be a derivative instrument in
its entirety. That determination is a matter of facts
and circumstances and shall be evaluated on a
case-by-case basis. Example 16, Case C (see paragraph
815-10-55-166) illustrates the guidance in this
paragraph.
15-98 The phrase initial
net investment is stated from the perspective of
only one party to the contract, but it determines the
application of this Subtopic for both parties. . . .
Initial Net Investment — Initial Exchange Under Currency
Swap Is Not an Initial Net Investment
55-8 The
definition of a derivative instrument includes contracts
that require gross exchanges of currencies (for example,
currency swaps that require an exchange of different
currencies at both inception and maturity). The initial
exchange of currencies of equal fair values in those
arrangements does not constitute an initial net
investment in the contract. Instead, it is the exchange
of one kind of cash for another kind of cash of equal
value. The balance of the agreement, a forward contract
that obligates and entitles both parties to exchange
specified currencies, on specified dates, at specified
prices, is a derivative instrument.
The second characteristic of a derivative in ASC 815-10-15-83 is that it has “no
initial net investment or an initial net investment that is smaller than would
be required for other types of contracts that would be expected to have a
similar response to changes in market factors.”
To evaluate this characteristic, an entity compares the following two amounts:
- The contract’s initial net investment.
- The amount needed to acquire (or incur) the effective notional amount of the asset (or liability) related to the contract’s underlying.
The characteristic is present if the initial net investment is smaller, by more
than a nominal amount, than that for other types of contracts with a similar
response to changes in market factors. For example, there is often no initial
investment required for freestanding swaps and forward contracts. For
freestanding option contracts, the initial investment (i.e., the premium) is
usually smaller than the amount needed to invest in the option’s reference
asset. If the contract’s initial investment approximates the initial investment
needed to acquire (or incur) the related asset (or liability), the net
investment characteristic is not met.
1.4.2.1 Smaller Initial Net Investment
A “smaller” initial net investment is an amount that is less, by more than a
nominal amount, than a party would have to pay for other types of contracts
that would have similar responses to changes in market conditions. A
derivative contract provides the holder with the opportunity to participate
in the price changes of the underlying without having to own the associated
asset or liability.
ASC 815 does not include a quantitative threshold for determining what “less,
by more than a nominal amount,” means in this context. In practice, an
initial net investment of 90 percent or less of the effective notional
amount is considered to meet the criterion in ASC 815-10-15-83(b). Said
differently, an initial net investment would typically be considered
“smaller” if it were at least 10 percent less that the initial net
investment needed to acquire (or incur) the related asset (or
liability).
As noted in ASC 815-10-15-98, “[t]he phrase initial net investment is stated
from the perspective of only one party to the contract, but it determines
the application of [ASC 815-10] for both parties.”
Example 1-3
Determining Whether There Is a Smaller Initial Net
Investment
There are various ways an entity can participate in
the increases and decreases in the price of 100
shares of ABC stock:
- Purchase 100 shares of ABC stock at $10 per share, which represents the current market value.
- Enter into a forward contract to buy 100 shares of ABC stock in the future at a fixed price. No exchange of cash is required on the date the forward contract is entered into.
- Purchase an option that allows the holder to buy 100 shares of ABC stock in the future with a strike price of $10 per share.
The purchase of the shares (alternative 1) would
require an initial investment equal to the current
market price for 100 shares of ABC and would give
the entity the right to vote the shares and receive
dividends.
The purchase of the forward contract (alternative 2)
at the current market forward price would require no
initial investment but would provide the same
opportunity to participate in stock price changes;
however, the entity would not have the right to vote
the shares or receive dividends.
The purchase of the option whose strike price is
equal to the current market value (alternative 3)
requires an initial net investment, but one that is
typically smaller than that for the acquisition of
the underlying shares themselves by more than a
nominal amount. However, the instrument provides
exposure to the same underlying (i.e., stock price
changes) and the entity usually does not have voting
or dividend rights.
Therefore, the “no or smaller initial net investment”
criterion of the definition of a derivative would be
met for both the forward and the option
(alternatives 2 and 3). The criterion would not be
met for the purchase of shares at market value
(alternative 1).
Typically, the purchase or sale of an option contract involves an initial
payment or the receipt of cash (the premium). Generally, this initial cash
investment represents the option’s time value, which would be considered a
“smaller” net investment under ASC 815. However, if the contract was
in-the-money at issuance and significant cash was exchanged, further
evaluation would be needed to determine whether the initial net investment
would meet the “smaller” criterion in the FASB’s definition. As indicated in
ASC 815-10-15-96, when the initial net investment in a contract is compared
with the investment that would be exchanged to either acquire the asset or
incur the obligation related to the underlying, the “amount of the asset
acquired or liability incurred should be comparable to the effective
notional amount,” which is the stated notional amount adjusted for any
leverage factor.
Example 1-4
Initial Net Investment in a Deep-in-the-Money
Option
XYZ Company purchases a deep-in-the-money American
call option on MNO stock, which is priced at $100
per share. The option has a 180-day maturity and a
strike price of $10 per share. XYZ pays a premium of
$90. Therefore, the initial investment in the option
($90) is less, by more than a nominal amount, than
the effective notional amount applied to the
underlying ($100).
Although the option has a significant initial net
investment, it is smaller, by more than a nominal
amount, than the investment that would be required
for other types of contracts expected to have a
similar response to changes in market factors. The
invested amount of $90 does not approximate the
effective notional amount applied to the underlying
and, therefore, the option meets the initial net
investment criteria for a derivative instrument. If
the initial net investment were greater than $90
(i.e., more than 90 percent of the effective
notional amount), XYZ would be required to use
judgment in determining whether the contract meets
the initial net investment criteria and should be
considered a derivative instrument.
In the evaluation of whether an embedded feature meets the definition of a
derivative, the initial net investment in the embedded feature is the amount
the entity would be required to invest in a freestanding contract with terms
that are similar to those of the embedded feature (i.e., it would not be
appropriate to consider the initial net investment in the hybrid
contract in the evaluation of whether this criterion is met).
Rather, the initial net investment of an embedded feature is the fair value
of that feature at the inception of the arrangement.
1.4.2.2 Concept of Effective Notional Amount
If the initial net investment required in a contract equals or exceeds the
amount calculated by applying the effective notional amount to the
underlying, the contract cannot be considered a derivative instrument. Case
A of Example 16 in ASC 815-10-55-150 through 55-154 illustrates a fact
pattern in which the initial net investment equals the amount calculated by
applying the effective notional amount to the underlying. Case B of Example
16 in ASC 815-10-55-156 through 55-158 illustrates a fact pattern in which
the initial net investment exceeds the amount determined by applying the
effective notional amount to the underlying.
ASC 815-10
15-95 A
derivative instrument does not require an initial
net investment in the contract that is equal to the
notional amount (or the notional amount plus a
premium or minus a discount) or that is determined
by applying the notional amount to the underlying. .
. .
15-97 A
contract that requires an initial net investment in
the contract that is in excess of the amount
determined by applying the effective notional amount
to the underlying is not a derivative instrument in
its entirety. Example 16, Case A (see paragraph
815-10-55-150) illustrates such a contract.
Example 16: Prepaid Interest Rate
Swap
Case A: Prepaid Interest Rate Swap
55-150 Entity A
pays $1,228,179 to enter into a prepaid interest
rate swap contract that requires the counterparty to
make quarterly payments based on a $10,000,000
effective notional amount and a variable interest
rate equal to 3-month U.S. dollar- (USD-)
denominated London Interbank Offered Rate (LIBOR).
The prepaid interest rate swap contract is
characterized as an at-the-money 2-year interest
rate swap with a $10,000,000 notional amount, a
fixed interest rate of 6.65 percent, and a variable
interest rate of the 3-month USD LIBOR (that is, the
same terms as the swap in Example 6 [see paragraph
815-30-55-24], which has a zero fair value at
inception), for which the fixed leg has been fully
prepaid. The amount of $1,228,179 is the present
value of the 8 quarterly fixed payments of $166,250
— that is, $10,000,000 × LIBOR swap rate of 6.65
percent / 4). The present value is based on the
implied spot rate for each of the 8 payment dates
under the assumed initial yield curve in that
Example.
55-151 The
prepaid interest rate swap contract could also be
characterized as a 2-year, structured note
(contract) with a principal amount of $1,228,179 and
loan payments based on a formula equal to 8.142
times 3-month USD LIBOR. (Note that 8.142 =
10,000,000 / 1,228,179.) The terms of the structured
note specify no repayment of the principal amount
either over the two-year term of the structured note
or at the end of its term. The 8.142 leverage factor
causes the effective notional amount of the
structured note also to be $10,000,000.
55-152 The
prepaid interest rate swap contract meets the
characteristic of a derivative instrument in
paragraph 815-10-15-83(a) because it has an
underlying and an effective notional amount. It also
meets the characteristic of a derivative instrument
in paragraph 815-10-15-83(c) because 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 (see paragraph 815-10-15-100). At issue is
whether the prepaid interest rate swap contract
meets the characteristic of a derivative instrument
described in paragraph 815-10-15-83(b) related to
the initial net investment in a contract.
55-153 The
prepaid interest rate swap contract does not meet
the definition of a derivative instrument because it
does not satisfy the characteristic of a derivative
instrument described in paragraph 815-10-15-83(b)
related to the initial net investment in the
contract. Specifically, the prepaid interest rate
swap contract is excluded from the definition of a
derivative instrument by the clarifying guidance on
initial net investment beginning in paragraph
815-10-15-94. The prepaid interest rate swap
contract in this Case requires an initial net
investment that is determined by applying the
effective notional amount of $10,000,000 to the
underlying (3-month USD LIBOR) for each of the 8
payment dates specified by the terms of the
contract. The initial net investment of $1,228,179
required to enter into the contract is the present
value of the 8 quarterly fixed-leg swap payments of
$166,250 — that is, $10,000,000 × 6.65 percent / 4.
Because the LIBOR swap rate reflects the applicable
portions of the forward three-month USD LIBOR rate
curve for the settlement dates that relate to the
specific payments under the swap, the initial net
investment is considered to have been determined by
applying the effective notional amount to the
underlying and then adjusted for the time value of
money.
55-154 That is,
as stated in paragraph 815-10-15-97, a contract that
requires an initial net investment in the contract
that is in excess of the amount determined by
applying the effective notional amount to the
underlying is also not a derivative instrument in
its entirety.
Case B: Prepaid Interest Rate Swap That Must Be
Bifurcated
55-156 Entity B
pays $1,782,245 to enter into a prepaid interest
rate swap contract that requires the counterparty to
make quarterly payments based on a $10,000,000
effective notional amount and a variable interest
rate equal to the sum of 3-month USD LIBOR and 300
basis points. The prepaid interest rate swap
contract is characterized as an at-the-money 2-year
interest rate swap with a $10,000,000 notional
amount, a fixed interest rate of 9.65 percent, and a
variable interest rate of 3-month USD LIBOR plus 300
basis points, for which the fixed leg has been fully
prepaid. The amount of $1,782,245 is the present
value of the 8 quarterly fixed payments of $241,250
— that is, $10,000,000 × the fixed rate of 9.65
percent / 4. The present value is based on the
implied spot rate for each of the 8 payment dates
under the assumed initial yield curve in Example 6
(see paragraph 815-30-55-24).
55-157 In this
Case, the underlying is 3-month USD LIBOR (even
though the variable rate is 3-month USD LIBOR plus
300 basis points) and the amount determined by
applying the effective notional amount to the
underlying (and then adjusted for the time value of
money) is $1,228,179, the same as in Case A. The
initial net investment for the prepaid interest rate
swap in this Case is $1,782,245, an amount that is
in excess of $1,228,179 — the amount referred to in
paragraph 815-10-15-95 as being determined by
applying the effective notional amount to the
underlying. Consequently, the prepaid interest rate
swap in this Case is not a derivative instrument in
its entirety.
55-158 Because
the prepaid interest rate swap contract is not a
derivative instrument in its entirety, it should be
evaluated to determine whether the contract contains
an embedded derivative that, pursuant to paragraph
815-15-25-1, requires separate accounting as a
derivative instrument.
As indicated in ASC 815-10-15-96, “[i]f the initial net investment [required]
in the contract is less, by more than a nominal amount, than the [amount
calculated by applying the effective notional amount to the underlying], the
characteristic in paragraph 815-10-15-83(b) is met.” Case C of Example 16 in
ASC 815-10-55-166 through 55-168 illustrates a fact pattern in which the
initial net investment is smaller than the amount determined by applying the
effective notional amount to the underlying.
ASC 815-10
15-96 If the
initial net investment in the contract (after
adjustment for the time value of money) is less, by
more than a nominal amount, than the initial net
investment that would be commensurate with the
amount that would be exchanged either to acquire the
asset related to the underlying or to incur the
obligation related to the underlying, the
characteristic in paragraph 815-10-15-83(b) is met.
The amount of that asset acquired or liability
incurred should be comparable to the effective
notional amount of the contract. This does not imply
that a slightly off-market contract cannot be a
derivative instrument in its entirety. That
determination is a matter of facts and circumstances
and shall be evaluated on a case-by-case basis.
Example 16, Case C (see paragraph 815-10-55-166)
illustrates the guidance in this paragraph.
Example 16: Prepaid Interest Rate
Swap
Case C: Prepaid Interest Rate Swap Variation
55-166 Entity C
pays $1,043,490 to enter into a contract that
requires the counterparty to make quarterly payments
based on a $10,000,000 effective notional amount and
a variable interest rate equal to the 3-month USD
LIBOR minus 100 basis points. In the event that
3-month USD LIBOR is less than 100 basis points,
Entity C is obligated to make payments to the
counterparty. The prepaid interest rate swap
contract is characterized as an at-the-money 2-year
interest rate swap with a $10,000,000 notional
amount, a fixed interest rate of 5.65 percent, and a
variable interest rate of 3-month USD LIBOR minus
100 basis points, for which the fixed leg has been
fully prepaid. The amount of $1,043,490 is the
present value of the 8 quarterly fixed payments of
$141,250 — that is, $10,000,000 × the fixed rate of
5.65 percent / 4. The present value is based on the
implied spot rate for each of the 8 payment dates
under the assumed initial yield curve in Example 6
(see paragraph 815-30-55-24).
55-167 In this
Case, the underlying is 3-month USD LIBOR (even
though the variable rate is 3-month USD LIBOR minus
100 basis points) and the amount determined by
applying the effective notional amount to the
underlying (and then adjusted for the time value of
money) is $1,228,179, the same as in Case A. The
initial net investment for the contract in this Case
is $1,043,490, an amount that is less than
$1,228,179. (The contract is considered not to be
fully prepaid because Entity C has not prepaid all
obligations imposed on it by the contract; Entity C
is obligated to make future payments under certain
conditions, as noted in the preceding paragraph.)
The difference of $184,689 (about 15 percent) is
more than a nominal amount if compared to
$1,228,179. Consequently, the contract in this Case
is a derivative instrument in its entirety.
55-168 The
amounts in this Case are not intended to provide
quantitative guidance for distinguishing between
being less by more than a nominal amount and being
less by only a nominal amount. The initial net
investment for a contract could be less than the
amount determined by applying the effective notional
amount to the underlying by a percentage lower than
15 percent and still be considered to be less, by
more than a nominal amount under paragraph
815-10-15-96.
Connecting the Dots
We are aware that the steep drop in U.S. interest rates before 2022
posed challenges for some entities using interest rate swaps to
hedge variable-rate debt obligations. As interest rates decreased
significantly, many such entities hoped to exit those interest rate
swaps since they had become significant balance sheet liabilities;
however, the counterparties to those swaps would have required
significant cash payments to terminate them. Alternatively, some
lenders and borrowers used a “blend and extend” strategy in which
the lenders agreed to restructure borrowers’ existing pay-fixed,
receive-variable interest rate swaps. Under this strategy, the
lender agrees to (1) extend the maturity date of the existing
interest rate swap and (2) revise the fixed interest rate. The new
fixed interest rate is determined such that the fair value of the
new swap (with the extended maturity date) approximates the current
fair value of the existing swap. The new swap’s fixed rate would be
higher than the rate of a new at-the-market swap but lower than the
existing swap’s rate.
Practitioners have questioned whether the modified derivative
contracts should continue to be accounted for as derivatives in
their entirety or, instead, as hybrid debt instruments. We believe
that the fair value of the existing derivative contract should be
considered the entity’s initial net investment in the new contract
under ASC 815-10-15-83(b). If the fair value of the existing swap is
large enough (i.e., greater than 90 percent of the effective
notional amount of the new derivative contract), the new derivative
contract would not meet the definition of a derivative under ASC
815-10-15-83 and should be considered a hybrid instrument with an
embedded derivative.
1.4.3 Net Settlement
1.4.3.1 Background
ASC 815-10
15-83 A derivative instrument
is a financial instrument or other contract with all
of the following characteristics: . . .
c. Net settlement. The contract
can be settled net by any of the following means:
- Its terms implicitly or explicitly require or permit net settlement.
- It can readily be settled net by a means outside the contract.
- It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
15-99 A contract fits the
description in paragraph 815-10-15-83(c) if its
settlement provisions meet criteria for any of the
following:
- Net settlement under contract terms
- Net settlement through a market mechanism
- Net settlement by delivery of derivative instrument or asset readily convertible to cash.
Under ASC 815, net settlement can be accomplished in three different ways:
- 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 notional amount (which may include a premium or discount). The contract is settled net (either in cash or any other asset) on the basis of changes in the price of the underlying (see Section 1.4.3.2).
- One of the parties is required to deliver an asset as described in criterion 1; however, there is a market mechanism that facilitates net settlement (see Section 1.4.3.3).
- One of the parties is required to deliver an asset as described in criterion 1; however, the asset either is RCC or is itself a derivative instrument (see Section 1.4.3.4).
The assessment of whether a contract meets the net settlement criteria is
done both at the inception of the contract and throughout the contract’s
life. For example, an arrangement may not meet the definition of a
derivative at contract inception because there is no net settlement, but
changes external to the contract (e.g., shares underlying the contract
become publicly traded in an active market) may cause the contract to meet
net settlement at a later date. See Section
1.4.3.4.5 for further discussion of this ongoing
assessment.
1.4.3.2 Net Settlement Under Contract Terms
ASC 815-10
Net Settlement Under Contract Terms
15-100 In this form of net
settlement, 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 (or the notional
amount plus a premium or minus a discount). (For
example, most interest rate swaps do not require
that either party deliver interest-bearing assets
with a principal amount equal to the notional amount
of the contract.) Net settlement may be made in cash
or by delivery of any other asset (such as the right
to receive future payments — see the discussion
beginning in paragraph 815-10-15-104), whether or
not that asset is readily convertible to cash.
15-101 Further considerations
in the application of this form of net settlement
are addressed as follows:
- Net share settlement
- Net settlement in the event of nonperformance or default
- Structured settlement as net settlement
- Net settlement of a debt instrument through exercise of an embedded put option or call option.
As stated in ASC 815-10-15-100, in a contractual net settlement, “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.” One
form of contractual net settlement is a one-way transfer of cash or assets,
such as a net amount of cash or a net number of shares (“cashless exercise”)
that is equivalent to the gain or loss on the contract. If the contractual
terms require or permit either party to elect net settlement, the net
settlement characteristic is met even if the item that may be delivered upon
settlement is not RCC (e.g., a net share settlement involving private
company shares).
Example 1-5
Net Settlement of Interest Rate Swaps
Company XYZ enters into an interest rate swap with a
counterparty that requires XYZ to pay a fixed rate
of 8 percent and receive three-month LIBOR, reset on
a quarterly basis. The fixed and variable amounts
are determined on the basis of a $100 million
notional amount. Company XYZ (1) pays the fixed-rate
amount on a semiannual basis to the counterparty and
(2) receives the variable amount on a quarterly
basis from the counterparty. The interest payments
are not settled on a net basis. Thus, the interest
rate swap constitutes a series of forward contracts
to exchange and receive cash on potentially
favorable or unfavorable terms. Each of the forward
contracts is a derivative instrument.
1.4.3.2.1 Net Share Settlement
ASC 815-10
Net Share Settlement
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.
ASC 815-10-15-100 indicates that explicit net settlement
in a contract as discussed in ASC 815-10-15-83(c) and ASC 815-10-15-99
can be achieved by delivery of (1) net cash or (2) net assets other than
cash, regardless of whether those net assets are RCC. ASC 815-10-15-102
notes that a net share-settled contract satisfies the net settlement
provision through the delivery of net assets. Since the net settlement
provision can be satisfied regardless of whether the net shares received
are RCC, even an equity instrument whose underlying is private-company
stock would satisfy the net settlement provisions of ASC 815.
The following are examples of common wording that is typically located in
the “manner of exercise” section of the instrument:
- “Cashless exercise.”
- “In lieu of payment of the exercise price.”
- “In lieu of cash payment.”
Example 1-6
Impact of Restrictions on the Net Settlement
Determination
Company M acquires a warrant to purchase 1,000
shares of Company P’s publicly traded stock for
$10 per share. Under the terms of the warrant, M
cannot sell any of P’s stock that it receives from
exercising the warrant for 60 days. The warrant
agreement allows for a “cashless exercise” option,
so that the fair value of the shares delivered
will equal the difference between the fair value
of 1,000 shares of P’s stock and $10,000 (the
strike price of the warrant). In other words, if
P’s stock is trading for $20, M could exercise the
warrant and elect to receive 500 shares, which is
calculated as [($20 – $10) × 1,000] ÷ $20, without
paying any cash. Even though the shares received
are not RCC because of the 60-day restriction
period (see Section 1.4.3.4.3), the
cashless exercise option would satisfy the
explicit net settlement criterion and the warrants
would meet the definition of a derivative.
Example 1-7
Cashless Exercise and Net Settlement
Company M acquires a warrant to purchase 20,000
shares of Company Q’s stock, which is not publicly
traded, for $4 per share. The warrant agreement
allows for a “cashless exercise” option, so that
the fair value of the shares delivered will equal
the difference between the fair value of 20,000
shares of Q stock and $80,000 (the strike price of
the warrant). In other words, if the fair value of
Q’s stock is $5, M could exercise the warrant and
elect to receive 4,000 shares, which is calculated
as [($5 – $4) × 20,000] ÷ $5, without paying any
cash. Even though the shares received are not RCC
because Q is not a public company, the cashless
exercise option would satisfy the explicit net
settlement criterion and the warrants would meet
the definition of a derivative.
1.4.3.2.2 Net Settlement in the Event of Nonperformance or Default
ASC 815-10
15-103 Penalties for
nonperformance may give a contract the
characteristic of net settlement. For example:
- A penalty for nonperformance in a purchase order is a net settlement provision if the amount of the penalty is based on changes in the price of the items that are the subject of the contract.
- A fixed penalty for nonperformance is not a net settlement provision.
- A contract that contains a variable penalty for nonperformance based on changes in the price of the items that are the subject of the contract does not contain a net settlement provision as discussed beginning in paragraph 815-10-15-100 if it also contains an incremental penalty of a fixed amount (or fixed amount per unit) that would be expected to be significant enough at all dates during the remaining term of the contract to make the possibility of nonperformance remote. If a contract includes such a provision, it effectively requires performance, that is, requires the party to deliver an asset that is associated with the underlying. The assessment of the fixed incremental penalty shall be performed only at the contract’s inception. The magnitude of the fixed incremental penalty shall be assessed on a standalone basis as a disincentive for nonperformance, not in relation to the overall penalty. . . .
As indicated in ASC 815-10-15-103(a), penalties for nonperformance might
satisfy the criterion of net settlement “if the amount of the penalty is
[computed on the basis of] changes in the price of the items that are
[covered by] the contract.” However, if the penalty is a fixed amount or
fixed amount per unit, it is not considered a net settlement provision
under ASC 815. In general, contracts that contain only a variable
penalty for nonperformance based on the changes in the price of the
underlying items satisfy the net settlement provision and, depending on
the other terms of the contract, may qualify as derivatives under ASC
815.
Under ASC 815-10-15-103(c), if the liquidating damages provisions require
both a fixed penalty and a variable penalty that are based on changes in
the price of the underlying asset, entities must use judgment to
determine whether the fixed penalty is sufficiently large “to make the
possibility of [net settlement] remote.” Entities should only assess the
fixed incremental penalty at the inception of the contract. ASC
815-10-15-103(c) also notes that “the magnitude of the fixed penalty
[should] be assessed on a standalone basis as a disincentive for
nonperformance, not in relation to the overall penalty.” If the fixed
penalty is determined to be sufficiently large to effectively require
performance, a net settlement provision is not present. See also ASC
815-10-55-10 through 55-18, which are discussed in Section
1.4.3.2.3.
Example 1-8
Fixed Versus Variable Penalty for
Nonperformance
Entity A entered into a forward contract to sell
fixed volumes of crude oil per day to Entity B for
five years starting in 20X5. For each barrel of
crude oil delivered, B will pay A the price equal
to NYMEX West Texas Intermediate calendar month
average for the month of delivery. If A fails to
deliver the contracted daily volumes of crude oil,
and such failure is not due to a force majeure
event, it pays a penalty per barrel as
follows:
Case A — $10
The penalty is not based on the price of the
crude oil but rather is a fixed amount per barrel
(i.e., $10). Since a fixed penalty for
nonperformance is not a net settlement, the
penalty does not result in net settlement of the
forward contract.
Case B — 1 Percent of the Price
The penalty is based on the price of the crude
oil (i.e., a variable penalty). Since the amount
of the penalty is computed on the basis of changes
in the prices of the items covered by the
contract, the forward can be net settled on the
basis of the contract terms.
Case C — 1 Percent of the Price Plus a
Significant Fixed Penalty per Unit
The penalty is based on the price of the crude
oil (i.e., a variable penalty) but also includes a
significant fixed penalty per unit. The presence
of a fixed significant penalty makes the
possibility of nonperformance remote on all dates
during the remainder of the contract. Therefore,
the penalty does not result in net settlement of
the forward contract.
1.4.3.2.3 Asymmetrical Default Provision Does Not Constitute Net Settlement
ASC 815-10
15-103 Penalties for
nonperformance may give a contract the
characteristic of net settlement. For example: . .
.
d. An asymmetrical default provision does not
give a commodity forward contract the
characteristic described as net settlement
beginning in paragraph 815-10-15-100. For related
implementation guidance, see the discussion
beginning in paragraph 815-10-55-10.
Asymmetrical Default Provision Does Not
Constitute Net Settlement
55-10 Many commodity forward
contracts contain default provisions that require
the defaulting party (the party that fails to make
or take physical delivery of the commodity) to
reimburse the nondefaulting party for any loss
incurred as illustrated in the following examples:
- If the buyer under the forward contract (Buyer) defaults (that is, does not take physical delivery of the commodity), the seller under that contract (Seller) will have to find another buyer in the market to take delivery. If the price received by Seller in the market is less than the contract price, Seller incurs a loss equal to the quantity of the commodity that would have been delivered under the forward contract multiplied by the difference between the contract price and the current market price. Buyer must pay Seller a penalty for nonperformance equal to that loss.
- If Seller defaults (that is, does not deliver the commodity physically), Buyer will have to find another seller in the market. If the price paid by Buyer in the market is more than the contract price, Seller must pay Buyer a penalty for nonperformance equal to the quantity of the commodity that would have been delivered under the forward contract multiplied by the difference between the contract price and the current market price.
55-11 For example, Buyer
agreed to purchase 100 units of a commodity from
Seller at $1.00 per unit:
- Assume Buyer defaults on the forward contract by not taking delivery and Seller must sell the 100 units in the market at the prevailing market price of $.75 per unit. To compensate Seller for the loss incurred due to Buyer’s default, Buyer must pay Seller a penalty of $25.00 — that is, 100 units × ($1.00 – $.75).
- Similarly, assume that Seller defaults and Buyer must buy the 100 units it needs in the market at the prevailing market price of $1.30 per unit. To compensate Buyer for the loss incurred due to Seller’s default, Seller must pay Buyer a penalty of $30.00 — that is, 100 units × ($1.30 – $1.00).
55-12 Note that an
asymmetrical default provision is designed to
compensate the nondefaulting party for a loss
incurred. The defaulting party cannot demand
payment from the nondefaulting party to realize
the changes in market price that would be
favorable to the defaulting party if the contract
were honored.
55-13 Under the forward
contract in the example, if Buyer defaults when
the market price is $1.10, Seller will be able to
sell the units of the commodity into the market at
$1.10 and realize a $10.00 greater gain than it
would have under the contract. In that
circumstance, the defaulting Buyer is not required
to pay a penalty for nonperformance to Seller, nor
is Seller required to pass the $10.00 extra gain
to the defaulting Buyer.
55-14 Similarly, if Seller
defaults when the market price is $.80, Buyer will
be able to buy the units of the commodity in the
market and pay $20.00 less than under the
contract. In that circumstance, the defaulting
Seller is not required to pay a penalty for
nonperformance to Buyer, nor is Buyer required to
pass the $20.00 savings on to the defaulting
Seller.
55-15 In a forward contract
with only an asymmetrical default provision,
neither Buyer nor Seller can realize the benefits
of changes in the price of the commodity through
default on the contract. That is, Buyer cannot
realize favorable changes in the intrinsic value
of the forward contract except in both of the
following circumstances:
- By taking delivery of the physical commodity
- In the event of default by Seller (which is an event beyond the control of Buyer).
55-16 Similarly, Seller
cannot realize favorable changes in the intrinsic
value of the forward contract except in either of
the following circumstances:
- By making delivery of the physical commodity
- In the event of default by Buyer, which is an event beyond the control of Seller.
55-17 However, a pattern of
having the asymmetrical default provision applied
in contracts between certain counterparties would
indicate the existence of a tacit agreement
between those parties that the party in a loss
position would always elect the default provision,
thereby resulting in the understanding that there
would always be net settlement. In that situation,
those kinds of commodity contracts would meet the
characteristic described as net settlement in
paragraph 815-10-15-100.
55-18 In contrast, a contract
that permits only one party to elect net
settlement of the contract (by default or
otherwise), and thus participate in either
favorable changes only or both favorable and
unfavorable price changes in the underlying, meets
the derivative characteristic described in
paragraph 815-10-15-83(c) and discussed in
paragraph 815-10-15-100 for all parties to that
contract. Such a default provision allows one
party to elect net settlement of the contract
under any pricing circumstance and consequently
does not require delivery of an asset that is
associated with the underlying. That default
provision differs from the asymmetrical default
provision in the example contract in paragraph
815-10-55-10 because it is not limited to
compensating only the nondefaulting party for a
loss incurred and is not solely within the control
of the defaulting party.
As noted in ASC 815-10-55-10, commodity forward contracts often “contain
default provisions that require the defaulting party (the party that
fails to make or take physical delivery of the commodity) to
[compensate] the nondefaulting party for any losses incurred.” Such
provisions are referred to as asymmetrical default provisions. In such
cases, the defaulting party would compensate the nondefaulting party for
losses but neither party can demand payment to realize favorable price
changes. Therefore, the terms do not meet the explicit or implicit net
settlement criteria.
Example 1-9
Asymmetrical Liquidating Damages
Provisions
Party A has a contract to purchase 1,000 units of
a raw material for $10 per unit. The default
provisions of the agreement require A to pay
Counterparty B in the event that A defaults and
the market price that B can obtain is less than
$10 per unit. In addition, the same penalty is
required if B defaults and A is required to
purchase the raw material in the market for more
than $10 per unit. The provisions are shown
below.
Contract price: $10 per unit for 1,000 units.
Market Price per Unit
|
Buyer Defaults
|
Seller Defaults
|
---|---|---|
$8.00
|
Buyer pays $2 per unit to the seller.
|
No payment. Buyer purchases in the market for
less.
|
$12.00
|
No payment. Seller sells in the market for
more.
|
Seller pays $2 per unit to the buyer.
|
The liquidating damages provisions in this
contract are asymmetrical because the defaulting
party only compensates the nondefaulting party for
losses but neither party can demand payment to
realize favorable price changes. Therefore, the
terms do not meet the explicit or implicit net
settlement criteria.
If the liquidating damages provisions stipulate a fixed penalty (e.g., in
the event of nonperformance, a penalty of $500,000 is assessed), a net
settlement provision is not present because the penalty is not based on
price changes but rather a predetermined fixed amount.
A contract that only permits one party to elect net settlement of the
contract (by default or otherwise), and thus participate in either
favorable or unfavorable price changes in the underlying, meets the
derivative characteristic described in ASC 815-10-15-83(c) (and
discussed in ASC 815-10-15-100) for all parties to that contract. Such a
default provision permits one party to elect net settlement of the
contract under any pricing circumstance, thereby avoiding the need to
deliver an asset associated with the underlying. By contrast, this
default provision differs from the asymmetrical default provision in ASC
815-10-55-10 because it is not limited to compensating only the
nondefaulting party for losses incurred.
1.4.3.2.4 Structured Settlement as Net Settlement
ASC 815-10
15-104 Upon settlement of a
contract, in lieu of immediate net cash settlement
of the gain or loss under the contract, the holder
may receive a financial instrument involving terms
that would provide for the gain or loss under the
contract to be received or paid over a specified
time period. A contract that provides for such a
structured payout of the gain (or loss) resulting
from that contract meets the characteristic of net
settlement in paragraphs 815-10-15-100 through
15-109 if the fair value of the cash flows to be
received (or paid) by the holder under the
structured payout are approximately equal to the
amount that would have been received (or paid) if
the contract had provided for an immediate payout
related to settlement of the gain (or loss) under
the contract. The fact that a contract
accomplishes settlement by requiring the party in
a loss position under the contract to make cash
payments over a specified timeframe to the party
in a gain position (in lieu of immediate cash
settlement of the gain) does not preclude the
contract from meeting the characteristic of net
settlement in those paragraphs.
15-105 A contract that
requires additional investing or borrowing to
obtain the benefits of the contract’s gain only
over time as a traditional adjustment of the yield
on the amount invested or the interest element on
the amount borrowed does not meet the
characteristic of net settlement.
15-106 Contracts that require
one party to the contract to invest funds in or
borrow funds from the other party so that the
party in a gain position under the contract can
obtain the value of that gain over time as a
nontraditional adjustment of the yield on the
amount invested or the interest element on the
amount borrowed may meet the characteristic of net
settlement. See related implementation guidance
beginning in paragraph 815-10-55-19.
Determining Whether a Structured Payout
Constitutes Net Settlement
55-19 Paragraph 815-10-15-104
explains that, upon settlement of a contract, in
lieu of immediate net cash settlement of the gain
or loss under the contract, the holder may receive
a financial instrument involving terms that would
provide for the gain or loss under the contract to
be received or paid over a specified time period.
Such a structured payout of the gain on a contract
could also be described as an abnormally high
yield on a required investment or borrowing in
which the overall return is related to the amount
of that contract’s gain, in which case the
contract would be considered to have met the
characteristic of net settlement in paragraph
815-10-15-100.
55-20 Assume, instead, that,
upon settlement of a contract, in lieu of
immediate net cash settlement of the gain or loss
under the contract, the holder is required to
invest funds in or borrow funds from the other
party so that the party in a gain position under
the contract can obtain the value of that gain
only over time as a traditional adjustment of the
yield on the amount invested or the interest
element on the amount borrowed. (A fixed-rate
mortgage loan commitment is an example of a
contract that requires the party in a gain
position under the contract to borrow funds at a
below-market interest rate at the time of the
borrowing to obtain the benefit of that gain.)
Paragraph 815-10-15-105 indicates that such a
contract does not meet the characteristic of net
settlement in paragraph 815-10-15-100.
55-21 In contrast, paragraph
815-10-15-106 explains that a contract that
requires one party to the contract to invest funds
in or borrow funds from the other party so that
the party in a gain position under the contract
can obtain the value of that gain over time as a
nontraditional adjustment of the yield on the
amount invested or the interest element on the
amount borrowed may meet the characteristic of net
settlement in paragraph 815-10-15-100. For
example, if a contract required the party in a
gain position under the contract to invest $100 in
the other party’s debt instrument that paid an
abnormally high interest rate of 5,000 percent per
day for a term whose length is dependent on the
changes in the contract’s underlying, an analysis
of those terms would lead to the conclusion that
the contract’s settlement terms were in substance
a structured payout of the contract’s gain and
thus that contract would be considered to have met
the characteristic of net settlement in that
paragraph.
In a structured payout, the net gain or loss under the
contract is paid over several periods rather than as an immediate cash
payment. The holder of the contract may receive a financial instrument
that provides for the gain or loss to be received or paid over a
specific period. As indicated in ASC 815-10-15-104, “if the fair value
of the cash flows to be received (or paid) by the holder under the
structured payout are approximately equal to the amount that would have
been received (or paid) if the contract had provided for an immediate
payout related to settlement of the gain (or loss) under the contract,”
the contract meets the requirements for net settlement in ASC
815-10-15-100 through 15-109. In other words, even a contract that calls
for settlement through cash payments over a specified period (instead of
immediate payment) from the party in a loss position to the party in a
gain position can still meet the criteria for net settlement.
1.4.3.2.5 Net Settlement of a Debt Instrument Through Exercise of an Embedded Put Option or a Call Option
ASC 815-10
15-107 The potential
settlement of the debtor’s obligation to the
creditor that would occur upon exercise of a put
option or call option embedded in a debt
instrument meets the net settlement criterion as
discussed beginning in paragraph 815-10-15-100
because neither party is required to deliver an
asset that is associated with the underlying.
Specifically:
- The debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option.
- The creditor does not receive an asset associated with the underlying.
15-108 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.
Under ASC 815-10-15-107 through 15-109, the “potential
settlement of a debtor’s obligation to the creditor that would occur
upon the exercise of a put option or call option [(including a
prepayment option)] embedded in a debt instrument meets the net
settlement criterion . . . in paragraph 815-10-15-100.” That paragraph
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 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. The guidance in ASC 815-10-15-107 through
15-109 does not apply to calls, puts, or other redemption features that
are embedded in equity host contracts. See Section 6.4.4 for further
discussion of this analysis for embedded features in debt hosts.
1.4.3.2.6 Contractual Net Settlement Only in Contingent Scenarios
Freestanding contracts may have terms that permit net settlement only
upon the occurrence of a contingent event. Guidance in ASC 815 does not
explicitly address whether such contracts meet the net settlement
criterion under ASC 815-10-15-83(c)(1), which states that the criterion
is satisfied if the contract’s “terms implicitly or explicitly require
or permit net settlement.”
We believe that contracts that provide for contingent net settlement
contain the characteristic of net settlement. In practice, freestanding
contracts that explicitly permit net settlement at the election of
either party to the contract are considered to meet the net settlement
criterion under ASC 815-10-15-83(c)(1) irrespective of whether the net
settlement feature is dependent on the occurrence or nonoccurrence of a
contingent event. Further, ASC 815-10-15-103 indicates that a “penalty
for nonperformance in a purchase order is a net settlement provision if
the amount of the penalty is based on changes in the price of the items
that are the subject of the contract.” That is, such guidance implies
that net settlement upon the occurrence of a contingent event
(nonperformance) constitutes net settlement as defined in ASC 815. In
addition, we believe that ignoring provisions that are only contingently
exercisable is generally inconsistent with ASC 815 principles (e.g.,
contingent embedded features are still evaluated for potential
bifurcation).
Example 1-10
Contingent Net Settlement
ABC issues a warrant to XYZ to
purchase shares of ABC’s common stock. The warrant
may be (1) exercised on a gross basis at XYZ’s
discretion by notice of exercise and delivery of
cash to ABC or (2) net share settled upon an
initial public offering (IPO) or a sale of ABC.
The warrant meets the conditions under ASC
815-10-15-83(a) and (b).
Although net settlement of the
warrant is contingent upon an IPO or sale of ABC,
the criterion in ASC 815-10-15-83(c)(1) is met
because the warrant explicitly permits and
provides for net share settlement.
Note that the fact pattern
described above differs from that of a warrant
that can only be exercised on a gross basis but
whose shares could theoretically become RCC after
an IPO. It would not be appropriate to conclude
that a warrant meets the net settlement criterion
simply because the warrant would meet the net
settlement criterion if
the shares became RCC in the future. (See Section
1.4.3.4 for further discussion of
instruments that are RCC.)
1.4.3.3 Net Settlement Through a Market Mechanism
ASC 815-10
15-110 In this
form of net settlement, one of the parties is
required to deliver an asset of the type described
in paragraph 815-10-15-100, but there is an
established market mechanism that facilitates net
settlement outside the contract. (For example, an
exchange that offers a ready opportunity to sell the
contract or to enter into an offsetting contract.)
Market mechanisms may have different forms. Many
derivative instruments are actively traded and can
be closed or settled before the contract’s
expiration or maturity by net settlement in active
markets.
15-111 The term
market mechanism is to be interpreted broadly and
includes any institutional arrangement or other
agreement having the requisite characteristics.
Regardless of its form, an established market
mechanism must have all of the following primary
characteristics:
- It is a means to settle a contract that enables one party to readily liquidate its net position under the contract. A market mechanism is a means to realize the net gain or loss under a particular contract through a net payment. Net settlement may occur in cash or any other asset. A method of settling a contract that results only in a gross exchange or delivery of an asset for cash (or other payment in kind) does not satisfy the requirement that the mechanism facilitate net settlement.
- It results in one party to the contract
becoming fully relieved of its rights and
obligations under the contract. A market mechanism
enables one party to the contract to surrender all
future rights or avoid all future performance
obligations under the contract. Contracts that do
not permit assignment of the contract from the
original issuer to another party do not meet the
characteristic of net settlement through a market
mechanism. The ability to enter into an offsetting
contract, in and of itself, does not constitute a
market mechanism because the rights and
obligations from the original contract survive.
The fact that an entity has offset its rights and
obligations under an original contract with a new
contract does not by itself indicate that its
rights and obligations under the original contract
have been relieved. This applies to contracts
regardless of whether either of the following
conditions exists:
- The asset associated with the underlying is financial or nonfinancial.
- The offsetting contract is entered into with the same counterparty as the original contract or a different counterparty (unless an offsetting contract with the same counterparty relieves the entity of its rights and obligations under the original contract, in which case the arrangement does constitute a market mechanism). (Example 6 [see paragraph 815-10-55-91] illustrates this guidance.)
- Liquidation of the net position does not require significant transaction costs. For purposes of assessing whether a market mechanism exists, an entity shall consider transaction costs to be significant if they are 10 percent or more of the fair value of the contract. Whether assets deliverable under a group of futures contracts exceeds the amount of assets that could rapidly be absorbed by the market without significantly affecting the price is not relevant to this characteristic. The lack of a liquid market for a group of contracts does not affect the determination of whether there is a market mechanism that facilitates net settlement because the test focuses on a singular contract. An exchange offers a ready opportunity to sell each contract, thereby providing relief of the rights and obligations under each contract. The possible reduction in price due to selling a large futures position is not considered to be a transaction cost.
- Liquidation of the net position under the contract occurs without significant negotiation and due diligence and occurs within a time frame that is customary for settlement of the type of contract. A market mechanism facilitates easy and expedient settlement of the contract. As discussed under the primary characteristic in (a), those qualities of a market mechanism do not preclude net settlement in assets other than cash.
15-113 Entities
shall consider the indicators in the following
paragraph for each of the primary characteristics in
determining whether a method of settling a contract
qualifies as an established market mechanism. All of
the indicators need not be present for an entity to
conclude that a market mechanism exists for a
particular contract.
15-114 The
following are indicators that the primary
characteristic in paragraph 815-10-15-111(a) is met:
- Access to potential counterparties is available regardless of the seller’s size or market position.
- Risks assumed by a market maker as a result of acquiring a contract can be transferred by a means other than by repackaging the original contract into a different form.
15-115 The
following are indicators that the primary
characteristic in paragraph 815-10-15-111(b) is met:
- There are multiple market participants willing and able to enter into a transaction at market prices to assume the seller’s rights and obligations under a contract.
- There is sufficient liquidity in the market for the contract, as indicated by the transaction volume as well as a relatively narrow observable bid-ask spread.
15-116 The
following are indicators that primary characteristic
in paragraph 815-10-15-111(d) is met:
- Binding prices for the contract are readily obtainable.
- Transfers of the instrument involve standardized documentation (rather than contracts with entity-specific modifications) and standardized settlement procedures.
- Individual contract sales do not require significant negotiation and unique structuring.
- The closing period is not extensive because of the need to permit legal consultation and document review.
15-118 The
evaluation of whether a market mechanism exists
shall be performed at inception and on an ongoing
basis throughout a contract’s life. Example 4, Case
A (see paragraph 815-10-55-86) illustrates this
guidance.
Example 4: Net Settlement at Inception and
Throughout a Contract’s Life
55-84 As
required by paragraphs 815-10-15-110 through 15-118
and 815-10-15-119 through 15-120, respectively, the
evaluation of whether a market mechanism exists and
whether items to be delivered under a contract are
readily convertible to cash must be performed at
inception and on an ongoing basis throughout a
contract’s life. For example, if a market develops,
if an entity effects an initial public offering, or
if daily trading volume changes for a sustained
period of time, then those events need to be
considered in reevaluating whether the contract
meets the definition of a derivative instrument.
Similarly, if events occur after the inception or
acquisition of a contract that would cause a
contract that previously met the definition of a
derivative instrument to cease meeting the criteria
(for example, an entity becomes delisted from a
national stock exchange), then that contract cannot
continue to be accounted for under this Subtopic.
The guidance in paragraphs 815-10-15-125 through
15-127 about assessing the significance of
transaction costs is not relevant when determining
whether such a contract no longer meets the
definition of a derivative instrument.
55-85 The
following Cases illustrate the importance of ongoing
evaluation:
- Market mechanism develops after contract inception (Case A). . . .
Case A: Market Mechanism Develops After Contract
Inception
55-86 A
purchase contract for future delivery of commodity X
is entered into and, at the inception of the
contract, the market for contracts on commodity X is
a relatively thin market, such that brokers do not
stand ready to buy and sell the contracts. As time
passes, the market for commodity X matures and
broker-dealer networks develop. The existence of the
broker-dealer market and the ability of the
purchaser to be relieved of its rights and
obligations under the purchase contract are
consistent with the characteristics of a market
mechanism as discussed beginning in paragraph
815-10-15-110. Accordingly, the purchase contract
will have the characteristics of net settlement as
defined by paragraph 815-10-15-110 as broker-dealer
networks develop.
A market mechanism enables one of the parties to a contract, which otherwise
requires physical delivery, to net settle. The determination of whether a
market mechanism exists should be made at the contract’s inception,
throughout the life of the contract, and when its terms are modified. Such a
determination should be made independently by each of the contract’s
counterparties.
ASC 815-10-15-111 states that “[t]he term market mechanism is to be
interpreted broadly and includes any institutional arrangement or other
agreement having the requisite characteristics” described in that paragraph.
Accordingly, an institutional arrangement or other agreement that provides a
party with the ability to enter into an offsetting contract (without
significant transaction costs) and relieves that party of all of its rights
and obligations under the original contract is a market mechanism.
The net settlement characteristic is met if an established market mechanism
exists that facilitates net settlement outside of the contract, such as the
ability to sell the derivative on an exchange. This condition does not apply
to embedded features since they cannot be settled separately from their host
contracts. If a feature is legally detachable and separately exercisable
from a contract, it is considered a separate freestanding financial
instrument, not an embedded feature.
Example 1-11
Determining Whether a Market Mechanism
Exists
On January 1, 20X1, XYZ enters into a long futures
contract (contract to buy) with a futures exchange.
The contract requires XYZ to take physical delivery
of 100,000 bushels of corn on March 1, 20X1. On
February 1, 20X1, XYZ enters into an offsetting
short futures contract (contract to sell), with the
same futures exchange, to deliver 100,000 bushels of
corn on March 1, 20X1. Upon entering into the
offsetting short position, the futures exchange
relieves XYZ of its rights and obligations under
both the long and short futures contracts since the
futures exchange in the United States acts as the
legal counterparty for all transactions. The
existence of the futures exchange means that there
is a market mechanism for net settling the original
derivative contract; therefore, a futures contract
will always be a derivative at its inception
regardless of whether the party intends to close out
its futures position at a future date and take
delivery of the asset.
By contrast, assume the same fact pattern as
described above, except that XYZ enters into a long
over-the-counter commodity contract that is not
traded on a futures exchange. Even though the
contract is not exchange-traded, there are brokers
who stand ready to buy and sell commodity contracts.
XYZ can enter into an offsetting short position and
be relieved of its right to accept delivery of the
commodity and its obligation to make payment under
the contract. To do so, it would arrange for a
broker to accept delivery and pay the broker a
commission plus any difference between the contract
price and the current market price of the commodity.
The commission paid to the broker would not be
significant. Since brokers stand ready to relieve
entities of their rights and obligations and XYZ
will not incur significant transaction costs, a
market mechanism for net settling the contract
exists.
Alternatively, if XYZ had entered into the original
contract in an over-the-counter market and had the
ability to enter into an offsetting short position
that would not relieve it of all of its rights and
obligations under the original over-the-counter
contract, a market mechanism would not have existed.
See also ASC 815-10-15-113 through 15-116.
1.4.3.3.1 Contracts With Market Makers
Most contracts entered into with a market maker would appear to have a
market mechanism because the market maker should be willing to enter
into an offsetting contract and relieve the entity of all of its rights
and obligations under the original contract.
Example 1-12
Market Mechanism and Market Maker
Contracts
Company A enters into a power purchase agreement
with Market Maker B that requires A to purchase
1,000 megawatts of electricity at a fixed price on
certain dates. It is presumed that B will enter
into an offsetting contract (power sales
agreement) with A if A chooses to close its
original position. Therefore, A would be able to
obtain relief from all of its rights and
obligations under most contracts entered into with
the market maker.
An exception to the general conclusion reached in the example above would
be if the two contracts could not be netted because of the bankruptcy of
one of the parties. In such a case, Company A would retain the
counterparty risk with respect to Market Maker B. However, since most
such transactions are conducted under enforceable master netting
arrangements, this circumstance is expected to be rare. The
determination of whether a market mechanism exists should be made
throughout the life of the contract (see ASC 815-10-55-84 through
55-89).
1.4.3.3.2 Market Mechanism on Non-Exchange-Traded Contracts
ASC 815-10
15-117 As noted in the
primary characteristic in paragraph
815-10-15-111(b), an assessment of the substance
of any assignment clause is required to determine
whether that assignment clause precludes a party
from being relieved of all rights and obligations
under the contract. Although permission to assign
a contract shall not be unreasonably withheld by
the counterparty in accordance with the terms of a
contract, an assignment feature cannot be viewed
simply as a formality because it may be invoked at
any time to prevent the nonassigning party from
being exposed to unacceptable credit or
performance risk. Accordingly, the existence of an
assignment clause may or may not permit a party
from being relieved of its rights and obligations
under the contract. If it is remote that the
counterparty will withhold permission to assign
the contract, the mere existence of the clause
shall not preclude the contract from possessing
the net settlement characteristic described in
paragraph 815-10-15-110 as a market mechanism.
Such a determination requires assessing whether a
sufficient number of acceptable potential
assignees exist in the marketplace such that
assignment of the contract would not result in
imposing unacceptable credit risk or performance
risk on the nonassigning party. Consideration
shall be given to past counterparty and industry
practices regarding whether permission to be
relieved of all rights and obligations under
similar contracts has previously been withheld.
However, if it is reasonably possible or probable
that the counterparty will withhold permission to
assign the contract, the contract does not possess
the net settlement characteristic described in
paragraph 815-10-15-110 as a market mechanism.
ASC 815 provides limited guidance on evaluating whether a market
mechanism exists when a contract is not exchange-traded. The primary
consideration in such an evaluation is determining whether one of the
parties to the contract could be relieved of all of its rights and
obligations under the terms of the contract other than through physical
settlement. This relief could be obtained through a transfer or
assignment provision that permits one party (or both parties) to the
contract to transfer its contract to a third party and to be relieved of
all of its rights and obligations under the contract. However, if a
contract could be transferred but there are no parties who would accept
such a transfer or assignment, no market mechanism would exist. If an
entity retains counterparty risk when transferring a contract, it has
not been relieved of its rights and obligations.
For example, a contract may state that an entity should obtain the
counterparty’s prior written approval before transferring its interest
in the contract and that such approval would not be unreasonably
withheld. If the counterparty approves the transfer or assignment and
the party is relieved of its rights and obligations under the contract,
a market mechanism exists. An entity should use judgment in evaluating
whether permission will be granted in such a case.
Under ASC 815-10-15-117, if it is reasonably possible or probable that
permission to transfer or assign a contract would be withheld, the
transfer or assignment provision does not provide a mechanism to access
a market. In other words, for a market mechanism to exist, the
likelihood that the counterparty will withhold such permission should be
remote (there also needs to be a market for such assignment). If
approval has not previously been granted (either by that counterparty or
other counterparties in similar transactions), that factor in and of
itself is not necessarily sufficient to determine that approval would
not be granted in the future. However, barring any other indicators, the
lack of history of granting approval may be strong evidence that it is
not remote that such permission would be withheld, which would support a
conclusion that no market mechanism exists.
On the other hand, some contracts specifically state that neither
counterparty may transfer its position to a third party. In this
circumstance, unless there is evidence to the contrary (e.g., a history
or pattern of settling the contract net or through an assignment), a
market mechanism for net settlement does not exist.
Some contracts are silent on transferability, which raises questions
about whether they could be transferred to another party and, if so,
whether the rights and obligations of the transferring party would be
relieved by doing so. In such contracts, whether an entity has the
ability to access a market is a legal issue that should be evaluated by
a legal specialist under the laws governing the contract. In some
situations, a contract may be silent regarding transferability but one
of the counterparties may have a previous pattern of settling such
contracts net by transferring them and being relieved of its rights and
obligations. An entity’s ability to transfer and be relieved of its
rights and obligations, while not contractually permitted, may provide
strong evidence that a formal or informal side agreement exists.
In some industries, an entity may have the ability to enter into a
contract to pair off its long or short position. Generally, a pair-off
provides an economic offset to the original contract, but it does not
provide for a release of the party’s rights and obligations under the
original contract (see ASC 815-10-55-91 through 55-98). The ability to
enter into a pair-off should be evaluated on the basis of individual
facts and circumstances to determine whether the pair-off constitutes a
market mechanism that relieves the party of its rights and obligations
under the original contract.
1.4.3.4 Net Settlement by Delivery of a Derivative Instrument or an Asset That Is RCC
ASC 815-10 — Glossary
Readily Convertible to Cash
Assets that are readily convertible to cash have both
of the following:
- Interchangeable (fungible) units
- Quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.
(Based on paragraph 83(a) of FASB Concepts Statement
No. 5, Recognition and Measurement in Financial
Statements of Business Enterprises.)
ASC 815-10
15-119 In this
form of net settlement, one of the parties is
required to deliver an asset of the type described
in paragraph 815-10-15-100, but that asset is
readily convertible to cash or is itself a
derivative instrument.
15-120 An example of a
contract with this form of net settlement is a
forward contract that requires delivery of an
exchange-traded equity security. Even though the
number of shares to be delivered is the same as the
notional amount of the contract and the price of the
shares is the underlying, an exchange-traded
security is readily convertible to cash. Another
example is a swaption — an option to require
delivery of a swap contract, which is a derivative
instrument.
15-121 Examples of assets
that are readily convertible to cash include a
security or commodity traded in an active market and
a unit of foreign currency that is readily
convertible into the functional currency of the
reporting entity.
15-122 An asset (whether
financial or nonfinancial) shall be considered to be
readily convertible to cash only if the net amount
of cash that would be received from a sale of the
asset in an active market is either equal to or not
significantly less than the amount an entity would
typically have received under a net settlement
provision. The net amount that would be received
upon sale need not be equal to the amount typically
received under a net settlement provision. Parties
generally should be indifferent as to whether they
exchange cash or the assets associated with the
underlying, although the term indifferent is
not intended to imply an approximate equivalence
between net settlement and proceeds from sale in an
active market.
15-123 The form of a
financial instrument is important; individual
instruments cannot be combined for evaluation
purposes to circumvent compliance with the criteria
beginning in paragraph 815-10-15-119. Example 8 (see
paragraph 815-10-55-111) illustrates this
guidance.
Asset’s Suitability as Collateral Does Not Equate
to Asset Being Readily Convertible to Cash
15-129 The ability to use a
security that is not publicly traded or an
agricultural or mineral product without an active
market as collateral in a borrowing does not, in and
of itself, mean that the security or the commodity
is readily convertible to cash.
The net settlement characteristic is met if the contract is
settled in a manner in which the recipient’s position is not substantially
different from that in a contractual net settlement. Thus, if a contract is
settled as a result of a two-way (gross) exchange of items that are RCC or
are derivatives, the net settlement characteristic is met. ASC 815-10-20
specifies that an item is RCC if it has both “[i]nterchangeable (fungible)
units” and “[q]uoted prices available in an active market that can rapidly
absorb the quantity held by the entity without significantly affecting the
price.”
As stated in ASC 815-10-15-129, even if any entity is able to use as loan
collateral “a security that is not publicly traded or [a commodity] without
an active market,” such ability “does not, in and of itself, mean that the
security or the commodity is readily convertible to cash.”
1.4.3.4.1 Determining Whether There Is an Active Market That Can Rapidly Absorb Shares of Stock
ASC 815-10
Determining Whether Shares of Stock Are
Readily Convertible to Cash
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.
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.
When a company enters into a contract, it should evaluate whether there
is an active exchange or market that quotes market prices for the type
of asset to be delivered under the contract. The entity should continue
to make such evaluations throughout the life of the contract.
If a contract requires physical settlement but the asset under the
contract is RCC, the contract can be de facto net settled according to
ASC 815. In a manner consistent with the RCC definition in the ASC
master glossary, an element of whether a contract is RCC depends on
determining how much the market can “rapidly absorb” without
significantly affecting the price. This is a matter of judgment and will
depend primarily upon the daily average trading volume of the asset
under contract. This evaluation should be made on an ongoing basis over
the life of the contract (as discussed in ASC 815-10-55-84 through
55-89).
When determining what the market can rapidly absorb upon the settlement
of a contract without significantly affecting the price, an entity
should contemplate this amount on the basis of the smallest
increment that can be exercised at any given time. This concept
is illustrated by the guidance in ASC 815-10-55-99 through 55-110, shown
above. For example, when evaluating whether the shares issuable upon
settlement of the convertible bond described in Case A of Example 7 in
ASC 815-10-55-101 through 55-108 are RCC, the entity does not need to
determine whether the market could rapidly absorb all of the shares that
would be issuable upon conversion of the entire bond. Rather, since the
conversion feature is exercisable in $1,000 increments of the bond, it
would only be necessary to determine that the market could rapidly
absorb the shares issuable upon the settlement of a single $1,000 bond
to conclude that the underlying shares are RCC.
In practice, contracts requiring delivery, on a single day, of 10 percent
or less of the average daily volume are considered RCC. If contracts
require delivery, on a single day, of more than 10 percent of the
average daily volume, entities should consider consulting a market
specialist who is knowledgeable about whether the number of shares
stipulated could be rapidly absorbed in the market without significantly
affecting the price.
As illustrated in ASC 815-10-55-99 through 55-110, the evaluation of
whether a contract is RCC is performed on the basis of the smallest
increment in which it can be settled.
Example 1-13
Shares of Stock Are RCC
Company T has a forward contract to purchase
100,000 shares of Company C’s common stock, which
is traded on the Nasdaq exchange, in one year. The
forward price on the contract is $100 per share.
On a specified single date in the future, the
contract requires T to take delivery of the
100,000 shares in exchange for $10 million in cash
(i.e., the contract does not provide for explicit
net settlement and, in this example, it is assumed
that no market mechanism exists for the forward
contract). The average daily trading volume of C’s
common shares is 1 million shares. Because 100,000
shares only represents 10 percent of the average
daily trading volume, T determines that a block of
100,000 of C’s common shares could be rapidly
absorbed in the market without significantly
affecting the price. Therefore, the asset to be
delivered under the forward contract is RCC.
Example 1-14
Shares of Stock May Not Be RCC
Assume the same facts as in the example above,
except that Company T’s contract allows for the
purchase of 500,000 shares of Company C’s common
stock. Since the average daily trading volume of
C’s common shares is 1 million shares and thus
500,000 shares equals 50 percent of the average
daily trading volume, it would typically be
reasonable to conclude that the shares could not
be rapidly absorbed in the market without
significantly affecting the price. As a result, T
determines that the shares would not be RCC.
ASC 815-10-15-128 indicates that when considering whether the market “can
rapidly absorb the quantity held by the entity” upon settlement of a
contract that involves multiple deliveries of the same asset, an entity
should perform separate evaluations for the quantity expected in each
delivery. Example 8 in ASC 815-10-55-111 through 55-117 illustrates this
concept.
ASC 815-10
Contracts Involving Multiple
Deliveries
15-128
For contracts that involve multiple deliveries of
the asset, the phrase in an active market that
can rapidly absorb the quantity held by the
entity in the definition of readily
convertible to cash shall be applied
separately to the expected quantity in each
delivery.
Example 8: Net Settlement — Effect of
Multiple Deliveries
55-111 This Example
illustrates the effect of multiple deliveries on
the consideration of net settlement described in
Section 815-10-15. An entity has a five-year
supply contract that obligates it to deliver at a
specified price each month a specified quantity of
a commodity that has interchangeable (fungible)
units and for which quoted prices are available in
an active market. However, the quoted prices that
are available are for either a spot sale or a
forward sale of the commodity with a maturity of
12 months or less. In other words, the forward
market for the commodity beyond the next 12 months
does not currently exist and is not expected to
develop. There are brokers who are willing to take
over the rights and obligations relating to the
next 12 months of the supply contract, but not for
periods beyond the next 12 months. With respect to
the active spot market for the commodity, it can
rapidly absorb the quantity specified in the
supply contract for each individual month but not
the total quantity for the entire five-year period
in a single transaction (or in multiple
transactions over the course of a day or so).
55-112 The supply contract
does not contain a net settlement provision as
described in paragraphs 815-10-15-100 through
15-109.
55-113 The 5-year commodity
supply contract does not meet the net settlement
characteristic in paragraph 815-10-15-110 at its
inception because there is no market mechanism to
net settle the entire 5-year contract — the
forward market exists only for the next 12 months
while the contract period is for the next 5 years.
Accordingly, there is no market mechanism for the
entity to settle the entire contract on a net
basis. However, if the contract contained
contractually separable increments that
individually met the net settlement criteria,
those contractually separable increments may be
embedded derivatives. In this instance, the
brokers in the market will not assume the rights
and obligations of the entire contract. Note that
the market mechanism in the net settlement
characteristic in paragraph 815-10-15-110 relates
to whether a party to the contract can be relieved
of its rights and obligations under the entire
contract, not merely whether an independent broker
in the market stands ready to assume the selected
rights and obligations.
55-114 The definition of a
derivative instrument in this Subtopic must be
applied based on the actual terms of the contract,
including its maturity date and the total quantity
of the underlying. This Subtopic does not permit
bifurcation of a 5-year contract into 5 annual
contracts, 60 monthly contracts, or 1,826 daily
contracts in an attempt to assert that only a
portion of the contract meets the definition of a
derivative instrument. To do so would be to
disregard one of the critical terms of the
contract, that is, the term to the maturity date
of the contract.
55-115 Based on the guidance
in paragraph 815-10-15-3, the five-year commodity
supply contract in the example, would, at the
beginning of the fifth year, be reevaluated to
determine whether the contract meets the net
settlement characteristic in paragraph
815-10-15-110 and would likely meet the
characteristic because a forward market for the
contract would then exist for the remaining term
of the contract.
55-116 The five-year
commodity supply contract meets the net settlement
characteristic as discussed beginning in paragraph
815-10-15-119. The criterion discussed beginning
in that paragraph is met because an active spot
market for the commodity exists today and is
expected to be in existence in the future for each
delivery date (for example, for quantities to be
delivered each day or each month for the next five
years) under the multiple delivery supply
contract. The spot market can rapidly absorb the
quantities specified for each monthly delivery
without significantly affecting the price. The
fact that the spot market may not be able to
absorb within a few days the quantity specified in
the entire five-year contract is irrelevant
because the performance of the contract is spread
out over a five-year period and, therefore, is not
expected to occur within a few days.
55-117 This Example does not
address whether or not the contract would qualify
for the normal purchases and normal sales scope
exception as discussed beginning in paragraph
815-10-15-22.
1.4.3.4.2 Evaluating the Impact of Conversion Costs on the RCC Assessment
ASC 815-10
Effect of Conversion Costs
15-125 If an entity
determines that the estimated costs that would be
incurred to immediately convert the asset to cash
are not significant, then receipt of that asset
puts the entity in a position not substantially
different from net settlement. Therefore, an
entity shall evaluate, in part, the significance
of the estimated costs of converting the asset to
cash in determining whether those assets are
readily convertible to cash.
15-126 For purposes of
assessing significance of such costs, an entity
shall consider those estimated conversion costs to
be significant only if they are 10 percent or more
of the gross sales proceeds (based on the spot
price at the inception of the contract) that would
be received from the sale of those assets in the
closest or most economical active market.
15-127 The assessment of the
significance of those conversion costs shall be
performed only at inception of the contract.
An equity conversion feature embedded in a debt host would be considered RCC if the shares that
would be delivered upon conversion could be rapidly absorbed in the
market without significantly affecting the stock price. If the
conversion costs (e.g., sales commissions on the quoted price) would
exceed 10 percent of the spot price at the inception of the contract,
however, the feature would not be considered RCC (see ASC
815-10-15-126).
When evaluating whether a physically settled commodity contract is RCC,
an entity should consider all costs it would expect to incur in taking
possession of the asset and converting it to cash (e.g., transportation,
temporary storage). Similarly, if such costs exceed 10 percent of the
spot price at the contract’s inception, the contract would not be
considered RCC.
1.4.3.4.3 Evaluating the Impact of Transfer Restrictions on the RCC Assessment
ASC 815-10
Determining Whether Shares of Stock Are
Readily Convertible to Cash
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.)
15-138 Paragraph
815-10-15-141 explains that the guidance in the
Certain Contracts on Debt and Equity Securities
Subsections applies to those warrants that are not
derivative instruments subject to this Topic but
that involve the acquisition of securities that
will be accounted for under either Topic 320 or
Topic 321. However, such warrants are not eligible
to be hedging instruments.
ASC 815-10-15-133 states, in part, that “[n]ewly 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).” However, ASC
815-10-15-136 notes that even when the restriction period is 31 days or
less, entities still need to evaluate “[w]hether an active market can
rapidly absorb the quantity of the issuing company’s stock to be
received upon exercise of the warrant without significantly affecting
the price [and whether] the other estimated costs to convert the stock
to cash are expected to not be significant.” Entities should only assess
the significance of those conversion costs at the inception of the
contract. Accordingly, entities should apply the guidance in ASC
815-10-15-125 through 15-127 to shares of stock received from stock
purchase warrants that are restricted for 31 days or less. Conversely,
if the shares are restricted for more than 31 days, the shares would not
be considered RCC.
In any case in which the underlying shares are restricted, securities law
counsel should be consulted to determine the nature of the restriction
and whether such restriction precludes any sale of the shares.
As noted in ASC 815-10-15-132, “[r]estrictions 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.”
Example 1-15
Assessment of RCC Criterion When Restrictions
Exceed 31 Days
Company X acquires a warrant from Company Z to
purchase 1,000 shares of Z’s stock, which is
traded on the New York Stock Exchange. The average
daily volume traded is 5 million shares. Under the
terms of the warrant, X cannot sell any shares of
Z’s stock it receives upon the exercise of the
warrant for 45 days. Therefore, the shares of Z’s
stock underlying the warrant are not considered
RCC because the restriction period (45 days) is
longer than 31 days.
Example 1-16
Assessment of RCC Criterion When Sales Are
Limited to Qualified Institutional Buyers
Company X acquires a warrant from Company Y to
purchase 1,000 shares of Y’s stock, which is
traded on the New York Stock Exchange. The average
daily volume of trading is 4 million shares. Under
the terms of the warrant, all shares of Y’s stock
received by X upon the exercise of the warrant are
subject to Rule 144 of the Securities Act of 1933
(the “Securities Act”) (i.e., they may only be
sold to qualified institutional buyers [QIBs]).
Under ASC 815-10-15-137, if shares of an actively
traded common stock that would be received upon
exercise of a stock purchase warrant are subject
to Rule 144 restrictions, such shares can
reasonably be expected to qualify for sale within
31 days of their receipt; accordingly, they could
be considered RCC. Therefore, despite the Rule 144
restrictions, X can conclude that it will be able
to sell Y’s stock (i.e., it may be sold to QIBs
during the restriction period). In this case, the
number of shares underlying the warrant (1,000)
could be rapidly absorbed by the market without
significantly affecting the price (see ASC
815-10-15). If the costs to convert Y’s stock to
cash are not expected to be significant, the stock
would be considered RCC and X would consider the
warrant to be a derivative (before considering the
applicability of any relevant scope
exceptions).
See Deloitte’s Roadmap Contracts on an Entity’s Own
Equity for more information about
this scope exception.
1.4.3.4.4 Determining Whether an Asset Is RCC for Both Parties to the Contract
Example 1-17
Impact of Contract Costs on the Assessment of
RCC Criterion
EnergyCo enters into a contract to provide 5,000
kilowatts of electricity to Customer ABC at a
fixed price for the next 24 months. Although the
market is deregulated, ABC does not have the
ability to trade in the market (i.e., resell any
excess electricity) because it lacks the required
licensing and permits. However, ABC can use either
EnergyCo or another party to resell the
electricity into the spot market on its behalf for
a fee. The total costs incurred by ABC would
include the true cost to resell the electricity
into the spot market (the market rate for
transmission, scheduling, etc.) plus the
commission charged by EnergyCo (or another party)
to resell on ABC’s behalf. Those costs would be
deemed significant since they would exceed 10
percent of the gross sale proceeds based on the
spot rate at inception of the contract. Therefore,
the asset to be delivered under the contract would
not be considered RCC for ABC.
In determining whether a contract meets the net settlement criterion,
each counterparty should make that assessment from its own perspective.
ASC 815-10-15-119 states, in part, that “one of the parties is required
to deliver an asset of the type described in paragraph 815-10-15-100,
but that asset is readily convertible to cash or is itself a derivative
instrument.” In the above example, the inability of the buyer
(Customer ABC) to resell the electricity and receive an amount that is
“not significantly less than the amount an entity would typically have
received under a net settlement provision” (see ASC 815-10-15-122) does
not affect the seller’s ability to net settle the contract. The
seller under this contract (EnergyCo) can wait until immediately before
the contractual delivery date and purchase the assets (electricity) to
be delivered on the spot market, effectively net settling the contract.
The determination of whether the assets are considered RCC from the
seller’s perspective should take into account whether the assets have
(1) interchangeable or fungible units and (2) a quoted market price that
is available in an active market that can rapidly sell the quantity of
the asset that needs to be purchased by the seller without significantly
affecting its price.
In such a circumstance, in a manner consistent with the concept of RCC,
the seller (EnergyCo) would not have to accept the risks and costs
related to owning the asset associated with the underlying and therefore
should not have to consider the buyer’s costs to resell the electricity.
As long as the seller’s costs to purchase and deliver the asset are not
significant (see ASC 815-10-15-125 through 15-127), the asset may be
considered RCC from the seller’s perspective. In performing its
analysis, the seller would consider the costs incurred to get the asset
from the closest or most economical active market to the delivery point
specified in the contract.
1.4.3.4.5 Ongoing Evaluation
ASC 815-10
15-127 The assessment of the
significance of . . . conversion costs shall be
performed only at inception of the contract.
15-139 The evaluation of
whether items to be delivered under a contract are
readily convertible to cash shall be performed at
inception and on an ongoing basis throughout a
contract’s life (except that, as stated in
paragraph 815-10-15-127, the assessment of the
significance of those conversion costs shall be
performed only at inception of the contract).
Example 4, Cases B, C, and D (see paragraphs
815-10-55-87 through 55-89) illustrate this
guidance.
Example 4: Net Settlement at Inception and
Throughout a Contract’s Life
55-84 As required by
paragraphs 815-10-15-110 through 15-118 and
815-10-15-119 through 15-120, respectively, the
evaluation of whether a market mechanism exists
and whether items to be delivered under a contract
are readily convertible to cash must be performed
at inception and on an ongoing basis throughout a
contract’s life. For example, if a market
develops, if an entity effects an initial public
offering, or if daily trading volume changes for a
sustained period of time, then those events need
to be considered in reevaluating whether the
contract meets the definition of a derivative
instrument. Similarly, if events occur after the
inception or acquisition of a contract that would
cause a contract that previously met the
definition of a derivative instrument to cease
meeting the criteria (for example, an entity
becomes delisted from a national stock exchange),
then that contract cannot continue to be accounted
for under this Subtopic. The guidance in
paragraphs 815-10-15-125 through 15-127 about
assessing the significance of transaction costs is
not relevant when determining whether such a
contract no longer meets the definition of a
derivative instrument.
55-85 The following Cases
illustrate the importance of ongoing evaluation:
- Market mechanism develops after contract inception (Case A).
- Initial public offering makes shares readily convertible to cash after contract inception (Case B).
- Increased trading activity makes shares readily convertible to cash after contract inception (Case C).
- Delisting makes shares not readily convertible to cash after contract inception (Case D).
Case A: Market Mechanism Develops After Contract
Inception
55-86 A purchase contract for
future delivery of commodity X is entered into
and, at the inception of the contract, the market
for contracts on commodity X is a relatively thin
market, such that brokers do not stand ready to
buy and sell the contracts. As time passes, the
market for commodity X matures and broker-dealer
networks develop. The existence of the
broker-dealer market and the ability of the
purchaser to be relieved of its rights and
obligations under the purchase contract are
consistent with the characteristics of a market
mechanism as discussed beginning in paragraph
815-10-15-110. Accordingly, the purchase contract
will have the characteristics of net settlement as
defined by paragraph 815-10-15-110 as
broker-dealer networks develop.
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.
As stated in ASC 815-10-15-139, the evaluation of
whether a contract meets the criteria in ASC 815-10-15-99(c) for RCC
should be made over the life of the contract (see ASC 815-10-55-87
through 55-89 for further guidance). However, an entity should not
reassess whether the costs to immediately convert the asset to cash
would exceed 10 percent of the spot price.
Options or warrants on nonpublic stock that require
gross physical settlement may not meet the definition of a derivative if
the underlying stock is not RCC. After an IPO, the stock underlying the
warrants may be RCC and the warrants could then meet the definition of a
derivative. If the number of shares underlying a warrant can be rapidly
absorbed by the market without significantly affecting the price and
there are no significant restrictions on the sale of the stock, the
warrants would be RCC and would therefore meet the definition of a
derivative under ASC 815. (As discussed in Example 1-10, such warrants would
generally not meet the definition of a derivative until the IPO
occurs.)
In addition, warrants for the purchase of a public company’s stock may
not be considered RCC when they are initially acquired because the
number of shares underlying the warrants could not be rapidly absorbed
by the market. However, if the average daily trading volume of the stock
increases, the number of shares underlying the warrant may become RCC
and would then meet the definition of a derivative under ASC 815.
1.5 Application of the ASC 815 Definition of a Derivative to Specific Contracts
The table below illustrates the
application of the ASC 815 definition of a derivative to different types of
contracts (before any scope exceptions are considered).
Contract
|
Does the contract have an underlying?
|
Does the contract have a notional amount or
payment provision?
|
Does the contract involve no or a smaller
initial net investment?
|
Does the contract require or permit net
settlement?
|
Does the contract need to be accounted for
as a derivative?3
|
---|---|---|---|---|---|
1,000 warrants to purchase 1,000 shares of an entity’s common
stock at a fixed exercise price
|
Yes, the price of the common stock.
|
Yes, the number of shares.
|
Yes, if the price paid for each warrant is at least 10
percent less than the fair value of a share of the entity’s
common stock.
|
Yes, (1) for contracts that provide for cashless exercise
(even if only contingently exercisable4) or whose settlement involves the delivery of shares
that are RCC or (2) if a market mechanism exists to net
settle the contract.
|
Warrants would typically meet the definition of a derivative
if net settlement is present.
|
Contract to pay a fixed dollar amount if the company’s common
stock rises above $10
|
Yes, the price of the common stock.
|
Yes, the fixed dollar amount is a payment provision.
|
Yes, if the price paid for the instrument is at least 10
percent less than the fixed dollar amount (i.e., the payoff
from the instrument).
|
Yes, the contract provides for a one-way transfer of cash, so
it is contractually net settled.
|
Typically, yes.
|
Short sales of securities (contract under which the short
seller borrows a security with a promise to return it to the
lender)
|
Yes, the price of the security.
|
Yes, the face amount of the security or the number of
shares.
|
No, the short seller received the fair value of the
security.
|
Yes, if the underlying securities are RCC.
|
No.
|
Managers’ options or overallotment provisions
|
Yes, the price of the underlying security.
|
Typically, yes.
|
Yes, if the price paid for the option is at least 10 percent
less than the fair value of the instrument underlying the
option.
|
Yes, if the underlying securities are RCC.
No, if the underlying securities are not RCC.
|
It depends, typically on the basis of whether the underlying
securities are RCC.
|
Banker’s acceptance agreement
|
Yes, the fair value of the receivable.
|
Yes, the aggregate dollar value of the receivable.
|
Typically, no, because the initial investment in the
instrument is not lower than 90 percent of the receivable’s
fair value.
|
No, there is typically no market mechanism to net settle the
contract, and the underlying is not RCC.
|
Typically, no, because it does not provide for net
settlement.
|
Irrevocable letter of credit
|
Yes, the fair value of the receivable.
|
Yes, the dollar value of the receivable.
|
It depends.
|
No, the receivable generally is not RCC and there is no
market mechanism.
|
Typically, no. A letter of credit would not meet the
definition of a derivative because it does not provide for
de facto net settlement.
|
Footnotes
3
The discussion in the table does not
consider the applicability of any of the scope
exceptions from derivative accounting provided by
ASC 815-10. In practice, more analysis would
typically be necessary before concluding that such
instruments must be accounted for as
derivatives.
4
See Section 1.4.3.2.6 for additional
guidance on how to evaluate contingent net
settlement provisions.
1.6 Unit of Account
ASC 815-10
Viewing a Contract as Freestanding or Embedded
15-5
The notion of an embedded derivative, as discussed in
paragraph 815-15-25-1, does not contemplate features that
may be sold or traded separately from the contract in which
those rights and obligations are embedded. Assuming they
meet this Subtopic’s definition of a derivative instrument,
such features shall be considered attached freestanding
derivative instruments rather than embedded derivatives by
both the writer and the current holder.
15-6 A
put or call option that is added or attached to a debt
instrument by a third party contemporaneously with or after
the issuance of the debt instrument shall be separately
accounted for as a derivative instrument under this Subtopic
by the investor (that is, by the creditor). An option that
is added or attached to an existing debt instrument by
another party results in the investor having different
counterparties for the option and the debt instrument and,
thus, the option shall not be considered an embedded
derivative. Paragraph 815-15-25-2 states that notion of an
embedded derivative in a hybrid instrument refers to
provisions incorporated into a single contract, and not to
provisions in separate contracts between different
counterparties.
15-7
If a debt instrument includes in its terms at issuance an
option feature that is explicitly transferable independent
of the debt instrument and thus is potentially exercisable
by a party other than either the issuer of the debt
instrument (the debtor) or the holder of the debt instrument
(the investor), that option shall be considered under this
Subtopic as an attached freestanding derivative instrument,
rather than an embedded derivative, by both the writer and
the holder of the option.
Viewing Two or More Contracts as a Unit in Applying the Scope
of This Subtopic
15-8
In some circumstances, an entity could enter into two or
more legally separate transactions that, if combined, would
generate a result that is economically similar to entering
into a single transaction that would be accounted for as a
derivative instrument under this Subtopic. For guidance on
circumstances in which two or more contracts that have been
determined to be derivative instruments within the scope of
this Subtopic must be viewed as a unit, see the guidance
beginning in paragraph 815-10-25-6. For guidance on
circumstances in which two or more contracts that have been
determined to be options within the scope of this Subtopic
must be viewed in combination, see the guidance beginning in
paragraph 815-10-25-7.
15-9
If two or more separate transactions may have been entered
into in an attempt to circumvent the provisions of this
Subtopic, the following indicators shall be considered in
the aggregate and, if present, shall cause the transactions
to be viewed as a unit and not separately:
- The transactions were entered into contemporaneously and in contemplation of one another.
- The transactions were executed with the same counterparty (or structured through an intermediary).
- The transactions relate to the same risk.
- There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.
A Transferable Option Is Considered Freestanding, Not
Embedded
55-3
Certain structured transactions involving the issuance of a
bond incorporate transferable options to call or put the
bond. As such, those options are potentially exercisable by
a party other than the debtor or the investor. For example,
certain put bond structures involving three separate parties
— the debtor, the investor, and an investment bank — may
incorporate options that are ultimately held by the
investment bank, giving that party the right to call the
bond from the investor. For example, a call option that is
transferable either by the debtor to a third party and thus
is potentially exercisable by a party other than the debtor
or by the original investor based on the legal agreements
governing the debt issuance can result in the investor
having different counterparties for the option and the
original debt instrument. Accordingly, even if incorporated
into the terms of the original debt agreement, such an
option may not be considered an embedded derivative by
either the debtor or the investor because it can be
separated from the bond and effectively sold to a third
party.
In the application of ASC 815, the unit of account is typically an
individual contract or an embedded feature within a contract. Unless a scope
exception applies, both freestanding derivative instruments and embedded derivative
components must be accounted for as derivatives under ASC 815. It is important to
identify whether a feature is embedded or freestanding because the incremental
guidance in ASC 815-15 affects whether an embedded feature requires separate
accounting recognition.
ASC 815-10-15-7 notes that if, upon issuance, an instrument includes “an option
feature that is explicitly transferable independent of the instrument and thus is
potentially exercisable by a party other than either the issuer or holder,” both the
option writer and holder should treat the option as a freestanding derivative
attached to the instrument instead of a derivative embedded in the instrument. As
noted in ASC 815-10-15-6, a “put or call option that is added or attached . . . by a
third party [either] contemporaneously with or after [initial] issuance of the debt
instrument” is an example of an attached feature that is considered
freestanding.
As indicated in ASC 815-10-15-8, there may be circumstances in which an entity enters
into legally separate transactions “that, if combined, would generate a result that
. . . would be accounted for as a derivative instrument” under ASC 815. ASC 815-10
contains additional guidance to help an entity determine whether two or more
separate transactions should be viewed as separate units of account or combined for
accounting purposes.
Nevertheless, ASC 815 ordinarily does not permit an entity to treat two or more
freestanding financial instruments as a single combined unit of account. DIG Issue
F6 (not codified) notes the following:
[ASC 815] is a transaction-based
standard.
Similarly, ASC 815-10-25-6 states, in part:
[ASC 815-10] generally does not
provide for the combination of separate financial instruments to be evaluated as
a unit.
However, if two or more freestanding financial instruments have characteristics
suggesting that they were structured to circumvent GAAP, they may need to be
combined and treated as a single unit of account. Specifically, ASC 815-10 requires
two or more separate transactions to be combined and viewed in combination as a
single unit of account if they were entered into in an attempt to circumvent the
accounting requirements for derivatives (i.e., measured at fair value, with
subsequent changes in fair value recognized in earnings except for qualifying
hedging instruments in cash flow or net investment hedges). ASC 815-10-15-9 states
that such combination is required if the transactions have all of the following
characteristics:
- They “were entered into contemporaneously and in contemplation of one another.”
- They “were executed with the same counterparty (or structured through an intermediary).”
- They “relate to the same risk” (e.g., the fair value of the issuer’s equity shares).
- “There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.”
ASC 815-10-25-6 identifies characteristics similar to those listed above from ASC
815-10-15-98 and adds the following commentary:
If separate derivative
instruments have all of [these] characteristics, judgment shall be applied to
determine whether the separate derivative instruments have been entered into in
lieu of a structured transaction in an effort to circumvent GAAP: . . . If such
a determination is made, the derivative instruments shall be viewed as a
unit.
ASC 815 does not specify a period of separation between transactions (e.g., one day,
one week) that would disqualify them from being treated as contemporaneous. A
one-week period between transactions may be sufficient evidence that the
transactions are not contemporaneous if the entity is exposed to market fluctuations
during this time. Thus, even when transactions occur at different times, entities
must consider all available evidence to ensure that no side agreements or other
contracts were entered into that call into question whether the transactions were
contemporaneous (e.g., there are no earlier agreements for trades to be entered into
simultaneously).
In the implementation guidance below, the FASB illustrates the unit of account
concepts:
- Example 1 in ASC 815-10-55-66 through 55-72 shows whether an attached (Case A) or transferable (Case B) call feature should be seen as a freestanding or embedded feature.
- Example 18 in ASC 815-10-55-171 through 55-174 and Example 19 in ASC 815-10-55-175 through 55-180 illustrate how to determine whether two transactions should be combined.
ASC 815-10
Example 1: Viewing a Contract as Freestanding or
Embedded
55-66 The following
Cases illustrate the application of paragraph 815-10-15-6:
- Attached call option (Case A)
- Transferable call option (Case B).
Case A: Attached Call Option
55-67 This Case
presents a transaction that involves the addition of a call
option contemporaneously with or after the issuance of
debt.
55-68 Entity X issues
15-year puttable bonds to an Investment Banker for $102. The
put option may be exercised at the end of five years.
Contemporaneously, the Investment Banker sells the bonds
with an attached call option to Investor A for $100. (The
call option is a written option from the perspective of
Investor A and a purchased option from the perspective of
the Investment Banker.) The Investment Banker also sells to
Investor B for $3 the call option purchased from Investor A
on those bonds. The call option has an exercise date that is
the same as the exercise date on the embedded put option. At
the end of five years, if interest rates increase, Investor
A would presumably put the bonds back to Entity X, the
issuer. If interest rates decrease, Investor B would
presumably call the bonds from Investor A.
55-69 As required by
paragraph 815-10-15-6, the call option that is attached by
the Investment Banker is a separate derivative instrument
from the perspective of Investor A.
Case B: Transferable Call Option
55-70 This Case
presents a group of transactions with a similar overall
effect to that in Case A.
55-71 Entity Y issues
15-year puttable bonds to Investor A for $102. The put
option may be exercised at the end of five years.
Contemporaneously, Entity Y purchases a transferable call
option on the bonds from Investor A for $2. Entity Y
immediately sells that call option to Investor B for $3. The
call option has an exercise date that is the same as the
exercise date of the embedded put option. At the end of five
years, if rates increase, Investor A would presumably put
the bonds back to Entity Y, the issuer. If rates decrease,
Investor B would presumably call the bonds from Investor
A.
55-72 As required by
paragraph 815-10-15-6, the call option is a separate
freestanding derivative instrument that must be reported at
fair value with changes in value recognized currently in
earnings unless designated as a hedging instrument.
Example 18: Recognition — Viewing Separate Transactions
as a Unit
55-171 The following
Cases illustrate when separate transactions should be viewed
as a unit:
- Swaps that should be viewed as a unit (Case A)
- Swaps that should not be viewed as a unit (Case B).
55-172 In Cases A and
B, an entity that is the issuer of fixed-rate debt enters
into an interest rate swap (Swap 1) and designates it as a
hedge of the fair value exposure of the debt to interest
rate risk. The fair value hedge of the fixed-rate debt
involving Swap 1 meets the required criteria in Section
815-20-25 to qualify for hedge accounting. The entity
simultaneously enters into a second interest rate swap (Swap
2) with the same counterparty with the exact mirror terms as
Swap 1 and does not designate Swap 2 as part of that hedging
relationship.
Case A: Swaps That Should Be Viewed as a Unit
55-173 If Swap 2 was
entered into in contemplation of Swap 1 and the overall
transaction was executed for the sole purpose of obtaining
fair value accounting treatment for the debt, it should be
concluded that the purpose of the transaction was not to
enter into a bona fide hedging relationship involving Swap
1. In that instance, the two swaps should be viewed as a
unit and the entity would not be permitted to adjust the
carrying value of the debt to reflect changes in fair value
attributable to interest rate risk.
Case B: Swaps That Should Not Be Viewed as a Unit
55-174 If Swap 2 was
not entered into in contemplation of Swap 1 or there is a
substantive business purpose for structuring the
transactions separately, and if both Swap 1 and Swap 2 were
entered into in arm’s-length transactions (that is, at
market rates), then the swaps should not be viewed as a
unit. For example, some entities have a policy that requires
a centralized dealer subsidiary to enter into third-party
derivative contracts on behalf of other subsidiaries within
the entity to hedge the subsidiaries’ interest rate risk
exposures. The dealer subsidiary also enters into internal
derivative contracts with those subsidiaries to
operationally track those hedges within the entity. (As
discussed beginning in paragraph 815-20-25-61, internal
derivatives do not qualify in consolidated financial
statements as hedging instruments for risks other than
foreign exchange risk.)
Example 19: Recognition — Viewing Separate Transactions
as a Unit for Purposes of Evaluating Net
Settlement
55-175 The following
Cases illustrate the guidance in paragraphs 815-10-15-8
through 15-9 on whether separate transactions should be
viewed as a unit for purposes of evaluating the
characteristic of net settlement:
- Two forward contracts viewed as a unit (Case A)
- Borrowing and lending transactions viewed as a unit (Case B).
55-176 In Cases A and
B, the transactions were entered into with the same
counterparty, were executed simultaneously, and relate to
the same risk.
Case A: Two Forward Contracts Viewed as a Unit
55-177 Entity A enters
into a forward contract to purchase 1,500,000 units of a
particular commodity in 3 months for $10 per unit.
Simultaneously, Entity A enters into a forward contract to
sell 1,400,000 units of the same commodity in 3 months for
$10 per unit. The purchase and sale contracts are with the
same counterparty. There is no market mechanism to
facilitate net settlement of the contracts, and both
contracts require physical delivery of the commodity at the
same location in exchange for the forward price. On a gross
basis, neither contract is readily convertible to cash
because the market cannot rapidly absorb the specified
quantities without significantly affecting the price.
However, on a net basis, Entity A has a forward purchase
contract for 100,000 units of the commodity, a quantity that
can be rapidly absorbed by the market and thus is readily
convertible to cash.
55-178 In this Case, it
appears that there is no clear business purpose for
structuring the transactions separately. Therefore, the
facts point to the conclusion that the purchase and sale
were done as a structured transaction with one counterparty
to circumvent the definition of a derivative instrument
under this Subtopic. However, if the facts indicated that
both contracts required physical delivery of the commodity
at different locations that are significantly distant from
one another and each counterparty is expected to deliver the
gross amount of the commodity to the other, those facts may
reflect a valid substantive business purpose for the
transaction.
Case B: Borrowing and Lending Transactions Viewed as a
Unit
55-179 Entity C loans
$100 to Entity B. The loan has a 5-year bullet maturity and
an 8 percent fixed interest rate, payable semiannually.
Entity B simultaneously loans $100 to Entity C. The loan has
a five-year bullet maturity and a variable interest of
LIBOR, payable semiannually and reset semiannually. Entity B
and Entity C enter into a netting arrangement that permits
each party to offset its rights and obligations under the
agreements. The netting arrangement meets the criteria for
offsetting in Subtopic 210-20. The net effect of offsetting
the contracts for both Entity B and Entity C is the economic
equivalent of an interest rate swap arrangement, that is,
one party receives a fixed interest rate from, and pays a
variable interest rate to, the other.
55-180 In this Case,
based on the facts presented, there is no clear business
purpose for the separate transactions, and they should be
accounted for as an interest rate swap under this Subtopic.
However, in other instances, a clear substantive business
purpose for entering into two separate loan transactions may
exist (for example, as a means to overcome foreign currency
expatriation restrictions).
Note that the SEC staff has indicated that it will challenge the
accounting for transactions that have been structured to circumvent GAAP. EITF Issue
02-2 (not codified) states, in part:
The SEC Observer
encouraged the [FASB] to examine the broader issue of when to combine
transactions and noted that, in the interim, the SEC staff will continue to
challenge the accounting for transactions for which it appears that multiple
contracts have been used to circumvent generally accepted accounting
principles.
ASC 815-10
Viewing Combinations of Options as Separate Options or
as a Single Forward Contract
25-7
This guidance addresses a combination of two options — one
that is a purchased call (put) option and another that is a
written put (call) option — having all of the following
characteristics:
- They have the same strike price, notional amount, and exercise date.
- They have the same underlying.
- Neither is required to be exercised.
25-8
The guidance addresses such options in two contexts:
- Combinations of two freestanding options or a freestanding and embedded option
- Combinations of two embedded options.
25-9
Derivative instruments that are transferable are, by their
nature, separate and distinct contracts. Accordingly, a
separate freestanding purchased call (put) option and
written put (call) option with all of the characteristics in
paragraph 815-10-25-7 convey rights and obligations that are
distinct whether involving the same or different
counterparties and do not warrant bundling as a single
forward contract for accounting purposes under this Subtopic
by any party to the contracts. (The separate purchased
option and written option can be viewed in combination and
jointly designated as the hedging instrument pursuant to
paragraph 815-20-25-45.)
Combinations of Two Freestanding Options or a Freestanding
and Embedded Option
25-9A
A combination of a freestanding purchased call (put) option
and a freestanding or embedded (nontransferable) written put
(call) option shall be considered for accounting purposes as
separate option contracts, rather than a single forward
contract, by both parties to the contracts even though all
of the following conditions are met:
- The options have the same terms.
- The options have the same underlying.
- The options are entered into contemporaneously with the same counterparty at inception.
25-9B
Both a combination of a freestanding purchased call (put)
option and a freestanding or embedded (nontransferable)
written put (call) option and a combination of a
freestanding written call (put) option and an embedded
(nontransferable) purchased put (call) option shall be
considered for accounting purposes as separate option
contracts, rather than a single forward contract, by both
parties to the contracts even though all of the following
conditions are met:
- The options have the same terms.
- The options have the same underlying.
- The options are entered into contemporaneously with different counterparties at inception.
Combinations of Two Embedded Options
25-10
A combination of an embedded (nontransferable) purchased
call (put) option and an embedded (nontransferable) written
put (call) option in a single hybrid instrument with all of
the characteristics in paragraph 815-10-25-7 and that are
entered into contemporaneously with the same counterparty
shall be considered as a single forward contract for
purposes of applying the provisions of this Subtopic. The
notion of the same counterparty encompasses contracts
entered into directly with a single counterparty and
contracts entered into with a single party that are
structured through an intermediary. (Note that a share of
stock being puttable by the holder and callable by the
issuer under the same terms does not render the stock
mandatorily redeemable under the provisions of Topic 480.)
Topic 480 requires that mandatorily redeemable financial
instruments be classified as liabilities.
25-11
The embedded options are in substance an embedded forward
contract because they meet both of the following conditions:
- They convey rights (to the holder) and obligations (to the writer) that are equivalent from an economic and risk perspective to an embedded forward contract.
- They cannot be separated from the hybrid instrument in which they are embedded.
25-12
Even though neither party is required to exercise its
purchased option, the result of the overall structure is a
hybrid instrument that will likely be redeemed at a point
earlier than its stated maturity. That result is expected by
both the hybrid instrument’s issuer and investor regardless
of whether the embedded feature that triggers the redemption
is in the form of two separate options or a single forward
contract.
25-13
However, if either party is required to exercise its
purchased option before the stated maturity date of the
hybrid instrument, the hybrid instrument shall not be viewed
for accounting purposes as containing one or more embedded
derivatives. In substance, the debtor (issuer) and creditor
(investor) have agreed to terms that accelerate the stated
maturity of the hybrid instrument and the exercise date of
the option is essentially the hybrid instrument’s actual
maturity date. As a result, it is inappropriate to
characterize the hybrid instrument as containing either of
the following:
- Two embedded option contracts that are exercisable only on the actual maturity date
- An embedded forward contract that is a combination of an embedded purchased call (put) and a written put (call) with the same terms.
In each of the scenarios contemplated by the guidance in ASC 815-10-25-7 through
25-13, both the purchased call (put) option and the written call (put) option have
the same strike price, notional amount, exercise date, and underlying, and neither
option is required to be exercised. To ascertain whether options must be bundled as
a single forward contract for accounting purposes under ASC 815, an entity must
determine whether they are freestanding or embedded:
- A “freestanding purchased call (put) option and written put (call) option with all of the characteristics in paragraph 815-10-25-7 convey [distinct] rights and obligations [regardless of whether the counterparties are] the same or different . . . and do not warrant bundling as a single forward contract for accounting purposes” (see ASC 815-15-25-9).
- The combination of two embedded options “that are entered into contemporaneously with the same counterparty shall be considered as a single forward contract for purposes of applying the provisions of [ASC 815]” (see ASC 815-15-25-10).
Chapter 2 — Scope and Scope Exceptions
Chapter 2 — Scope and Scope Exceptions
2.1 Overview
ASC 815-10
15-1 This Subtopic
applies to all entities. Some entities, such as
not-for-profit entities (NFPs) and defined benefit pension
plans, do not report earnings as a separate caption in a
statement of financial performance. The application of this
Subtopic to those entities is set forth in paragraphs
815-10-35-3, 815-20-15-1, 815-25-35-19, and 815-30-15-3.
15-2 The scope of this
Subtopic relates primarily to whether a contract meets the
definition of a derivative instrument (see paragraph
815-10-15-83). However, as discussed in this Subsection,
some contracts that meet the definition of derivative
instrument are not within the scope of this Subtopic, while
other contracts that do not meet the definition of
derivative instrument are within the scope of this Subtopic.
Some of the disclosure requirements in Section 815-10-50
apply to nonderivative instruments that are designated and
qualify as hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66.
The guidance in ASC 815 applies to all entities. Entities that do not report earnings
separately in their financial statements (e.g., nonprofit entities and defined
benefit pension plans) must recognize the gain or loss on a nonhedging derivative
instrument as a change in their net assets.
ASC 815 focuses on instruments and contracts that meet the definition of a derivative
(see Chapter 1). However, certain instruments
and contracts meet the definition of a derivative as described in ASC 815-10-15-83
but are appropriately excluded from the scope of the guidance in ASC 815 if any of
the available scope exceptions apply (see Section
2.3). Conversely, certain instruments that do not meet the definition
of a derivative are actually included in the scope of ASC 815 and therefore subject
to its requirements (see Section 2.2).
2.2 Scope Inclusions
Forward commitment dollar rolls are specifically included in the scope of ASC 815,
regardless of whether they meet the definition of a derivative in ASC
815-10-15-83.
ASC 815-10 — Glossary
Forward Commitment Dollar Roll
See Government National Mortgage Association Rolls.
ASC Master Glossary
Government National Mortgage Association Rolls
The term Government National Mortgage Association (GNMA)
rolls has been used broadly to refer to a variety of
transactions involving mortgage-backed securities,
frequently those issued by the GNMA. There are four basic
types of transactions:
-
Type 1. Reverse repurchase agreements for which the exact same security is received at the end of the repurchase period (vanilla repo)
-
Type 2. Fixed coupon dollar reverse repurchase agreements (dollar repo)
-
Type 3. Fixed coupon dollar reverse repurchase agreements that are rolled at their maturities, that is, renewed in lieu of taking delivery of an underlying security (GNMA roll)
-
Type 4. Forward commitment dollar rolls (also referred to as to-be-announced GNMA forward contracts or to-be-announced GNMA rolls), for which the underlying security does not yet exist.
ASC 815-10
15-12 A forward
commitment dollar roll that does not meet the definition of
a derivative instrument is within the scope of the guidance
specified for such contracts in this Subtopic (see
paragraphs 815-10-25-15, 815-10-30-4, and 815-10-35-4).
25-15 Forward
commitment dollar rolls that are not otherwise subject to
this Subtopic’s provisions shall be recognized as either
assets or liabilities depending on the rights or obligations
under the contracts.
30-4 A forward
commitment dollar roll that is not subject otherwise to this
Subtopic’s provisions shall be measured initially at fair
value.
35-4 A forward
commitment dollar roll that is not subject otherwise to this
Subtopic’s provisions shall be measured subsequently at fair
value.
Entities are required to measure a forward commitment dollar roll both initially and
subsequently at fair value, even if it does not meet the definition of a derivative
in ASC 815.
2.3 Scope Exceptions
ASC 815-10
Instruments Not
Within Scope
15-13 Notwithstanding the
conditions in paragraphs 815-10-15-83 through 15-139, the
following contracts are not subject to the requirements of
this Subtopic if specified criteria are met:
-
Regular-way security trades
-
Normal purchases and normal sales
-
Certain insurance contracts and market risk benefits
-
Certain financial guarantee contracts
-
Certain contracts that are not traded on an exchange
-
Derivative instruments that impede sales accounting
-
Investments in life insurance
-
Certain investment contracts
-
Certain loan commitments
-
Certain interest-only strips and principal-only strips
-
Certain contracts involving an entity’s own equity
-
Leases
-
Residual value guarantees
-
Registration payment arrangements
-
Certain fixed-odds wagering contracts.
This section addresses the various scope exceptions provided by ASC 815. If any of
the available scope exceptions apply, it would be appropriate for the entity to
not apply the guidance within this topic, even if the definition of a
derivative was otherwise met. Each of these scope exceptions is discussed in more
detail in the subsequent sections.
2.3.1 Regular-Way Security Trades
ASC 815-10 — Glossary
Regular-Way Security Trades
Regular-way security trades are contracts that provide
for delivery of a security within the period of time
(after the trade date) generally established by
regulations or conventions in the marketplace or
exchange in which the transaction is being executed.
ASC 815-10
Regular-Way Security Trades
15-15
Regular-way security trades are defined as contracts
that provide for delivery of a security within the
period of time (after the trade date) generally
established by regulations or conventions in the
marketplace or exchange in which the transaction is
being executed. For example, a contract to purchase or
sell a publicly traded equity security in the United
States customarily requires settlement within three
business days. If a contract for purchase of that type
of security requires settlement in three business days,
the regular-way security trades scope exception applies,
but if the contract requires settlement in five days,
the regular-way security trades scope exception does not
apply unless the reporting entity is required to account
for the contract on a trade-date basis.
15-16 Except
as provided in (a) in the following paragraph, a
contract for an existing security does not qualify for
the regular-way security trades scope exception if
either of the following is true:
-
It requires or permits net settlement (as discussed in paragraphs 815-10-15-100 through 15-109).
-
A market mechanism exists to facilitate net settlement of that contract (as discussed in paragraphs 815-10-15-110 through 15-118).
15-17 The
scope exception for regular-way security trades applies
only to a contract that requires delivery of securities
that are readily convertible to cash except that the
scope exception also shall or may apply in any of the
following circumstances:
-
If an entity is required, or has a continuing policy, to account for a contract to purchase or sell an existing security on a trade-date basis, rather than a settlement-date basis, and thus recognizes the acquisition (or disposition) of the security at the inception of the contract, then the entity shall apply the regular-way security trades scope exception to that contract.
-
If an entity is required, or has a continuing policy, to account for a contract for the purchase or sale of when-issued securities or other securities that do not yet exist on a trade-date basis, rather than a settlement-date basis, and thus recognizes the acquisition or disposition of the securities at the inception of the contract, that entity shall apply the regular-way security trades scope exception to those contracts.
-
Contracts for the purchase or sale of when-issued securities or other securities that do not yet exist, except for those contracts accounted for on a trade-date basis, are excluded from the requirements of this Subtopic as a regular-way security trade only if all of the following are true:
-
There is no other way to purchase or sell that security.
-
Delivery of that security and settlement will occur within the shortest period possible for that type of security.
-
It is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery of a security when it is issued. (The entity shall document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.)
-
Example 9 (see paragraph 815-10-55-118) illustrates the
application of item (c) in this paragraph.
15-18 Note
that contracts that require delivery of securities that
are not readily convertible to cash (and thus do not
permit net settlement) are not subject to the
requirements of this Subtopic unless there is a market
mechanism outside the contract to facilitate net
settlement (as described in paragraph
815-10-15-110).
There is usually a time lag between the trade date and settlement date of a
security trade, which technically creates a forward contract to purchase or sell
the specified security on the settlement date. This type of forward contract
often meets the definition of a derivative (before consideration of the
applicability of any scope exceptions) because (1) it has an underlying (i.e.,
the fair value of the equity security) and a notional amount (the number of
equity securities), (2) it requires no initial net investment, and (3) the
underlying equity securities are often RCC. However, some securities trades may
qualify for the scope exception for regular-way security trades.
As indicated in the ASC 815-10 definition above, regular-way
security trades are “contracts that provide for delivery of a security within
the period of time (after the trade date) generally established by regulations
or conventions in the marketplace or exchange in which the transaction is being
executed.” The concept of a regular-way security trade is not based on the
normal practices of an individual entity but rather on marketplace conventions
or regulations.
The scope exception for regular-way security trades would only apply to contracts
that require the delivery of assets that qualify as RCC. Therefore, the market
associated with the assets would typically be expected to have sufficient
trading volume such that the conventions or regulations of the market would be
well understood.
As noted in ASC 815-10-15-15 above, if it is either required or customary for
certain securities on a specified exchange to settle within three days, a
contract that requires settlement in more than three days is not a regular-way
security trade even if the entity customarily enters into contracts to purchase
securities that require settlement more than three days in the future. In the
United States, most equity security trades now settle in two business days.
Given that the intent of the guidance in ASC 815-10-15-15 is that the period
should be generally established by regulations or conventions in the
marketplace, we believe that for U.S. security trades, a settlement period that
is longer than the current convention of two days would not qualify for this
scope exception.
Changing Lanes
On February 15, 2023, the SEC adopted a final
rule to transition the securities settlement cycle
for most broker-dealer transactions in the United States from two days
to one. The rule becomes effective on May 28, 2024. Until this rule
takes effect, the scope exception for regular-way security trades will
continue to be applicable to contracts settling within two days;
however, expect this to change once the rule becomes effective.
Example 2-1
Regular-Way Trades
Company XYZ purchases 100,000 shares of Company ABC, a
NYSE-listed entity, through a U.S. broker on Monday,
October 1, 20X0. The average daily trading volume of the
stock is 1 million shares. The settlement date of the
contract is Wednesday, October 3, 20X0. Because the
settlement date (October 3) is after the trade date
(October 1), the contract is considered to be a forward
to purchase shares.
Further analysis indicates that the
forward meets the definition of a derivative since it
has an underlying (the fair value of ABC’s common stock)
and a notional amount (100,000 shares), no initial net
investment was made, and XYZ will take delivery of an
asset (ABC’s stock) that is RCC.1 However, the contract qualifies for the derivative
scope exception in ASC 815-10-15-13(a) for regular-way
security trades since the customary delivery time for
physical settlement of a forward purchase or sale of
traded securities is two business days in the United
States. Therefore, this two-day forward purchase
contract would not be accounted for as a derivative
under ASC 815.
By contrast, if the contract was entered into on Monday,
October 1, 20X0, and delivery was scheduled on Friday,
October 5, 20X0, it would not qualify for the scope
exception because settlement would be outside the
customary period in the market in which the contract was
entered. In that case, the contract would be accounted
for as a derivative at fair value.
ASC 815-10-15-16 states that a “contract for an existing security does not
qualify for the regular-way security trades scope exception if either of the
following is true:
-
It requires or permits net settlement (as discussed in paragraphs 815-10-15-100 through 15-109).
-
A market mechanism exists to facilitate net settlement of that contract (as discussed in paragraphs 815-10-15-110 through 15-118).”
As indicated in ASC 815-10-15-17(a), regardless of whether a contract allows or
requires net settlement or whether there is a market mechanism to facilitate net
settlement, “[i]f an entity is required, or has a continuing policy, to account
for a contract to purchase or sell an existing security on a trade-date
basis,”2 it can apply the exception for regular-way security trades to the
contract. ASC 815-10-15-17(b) extends that guidance to “when-issued securities
or other securities that do not yet exist.”
ASC 815-10-15-17(c) exempts forward purchases or sales of when-issued securities
or other securities that do not yet exist from the provisions of ASC 815 for
regular-way securities trades if all three of the following criteria are met:
-
There is no other way to purchase or sell that security.
-
Delivery of that security and settlement will occur within the shortest period possible for that type of security.
-
It is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery of a security when it is issued. (The entity shall document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.)
The implementation guidance below illustrates the application of the guidance on
regular-way security trades.
ASC 815-10
Example 9: Regular-Way Security Trades —
Shortest-Period Criterion
55-118 This
Example illustrates the application of paragraph
815-10-15-17(c). Assume a variety of forward contracts
exists for a when-issued security, such as a
to-be-announced security, that provides a choice of
settlement dates for each of the next three months (such
as November, December, or January). An entity enters
into a forward contract to purchase the to-be-announced
security, which will otherwise meet the qualifications
of paragraphs 815-10-15-13 through 15-20, that requires
delivery in the second-nearest month (such as December),
not the nearest month (such as November). The entity may
not apply the regular-way security trade exception to
the forward purchase contract that requires delivery of
the to-be-announced security in the second-nearest month
(such as December).
55-119 In
this Example, the to-be-announced security (identified
by issuer, contractual maturity of the underlying loans,
and the net coupon, such as 30-year Government National
Mortgage Association [GNMA] securities bearing interest
of 7 percent) is available under multiple settlement
periods (that is, the standardized settlement date in
November, December, or January). The regular-way
security trade exception may be applied only to forward
contracts for that to-be-announced security that require
delivery in November, the shortest period permitted for
that type of to-be-announced security. The December and
January settlement to-be-announced forward contracts
must be accounted for as derivative instruments under
this Subtopic.
55-120 If the
forward contracts in this Example meet the hedge
accounting criteria, they may be designated in cash flow
hedges of the anticipated purchase of the securities, as
discussed in paragraph 815-20-25-22.
2.3.2 Normal Purchases and Normal Sales
ASC 815-10
15-22 Normal
purchases and normal sales are contracts that provide
for the purchase or sale of something other than a
financial instrument or derivative instrument that will
be delivered in quantities expected to be used or sold
by the reporting entity over a reasonable period in the
normal course of business.
15-23 The
assessment of whether a contract qualifies for the
normal purchases and normal sales scope exception
(including whether the underlying of a price adjustment
within the contract is not clearly and closely related
to the asset being sold or purchased) shall be performed
only at the inception of the contract.
15-24 The
normal purchases and normal sales scope exception
sometimes will result in different parties to a contract
reaching different conclusions about whether the
contract is required to be accounted for as a derivative
instrument. For example, the contract may be for
ordinary sales by one party but not for ordinary
purchases by the counterparty.
15-25
Following are discussions of four important elements
needed to qualify for the normal purchases and normal
sales scope exception:
-
Normal terms (including normal quantity)
-
Clearly and closely related underlying
-
Probable physical settlement
-
Documentation.
As discussed in ASC 815-10-15-22, ASC 815 does not apply to contracts in which
“something other than a financial instrument or derivative instrument” is
purchased or sold “in quantities [that will be] used or sold by the reporting
entity over a reasonable period in the normal course of business.” ASC
815-10-15-24 further notes that it is possible that counterparties to a contract
may reach “different conclusions about whether the contract is required to be
accounted for as a derivative instrument” because of the normal purchases and
normal sales (NPNS) scope exception.
In assessing whether a contract qualifies for the NPNS scope exception, entities
should consider the following:
-
Contracts whose price is based on an underlying index that is not clearly and closely related to the asset being sold or purchased (e.g., a grain commodity price based on changes in the S&P index) do not qualify (see ASC 815-10-15-30 through 15-34 for further interpretation of the meaning of “not clearly and closely related” as it applies to the NPNS scope exception).
-
Contracts that contain net settlement provisions may qualify for the exception if “[i]t is probable at inception and throughout the term of the contract that the contract will not settle net and will result in physical delivery” (see the net settlement provisions of ASC 815-10-15-100 through 15-109 and the market mechanism provisions of ASC 815-10-15-110 through 15-118). Net settlement of similar contracts would call into question the classification of such contracts as normal purchases or sales.
-
To qualify for the exception, the contracts must be denominated in (1) the functional or local currency of one of the substantial parties to the contract, (2) the currency in which the price of the underlying is routinely denominated in international commerce (e.g., U.S. dollars for crude oil transactions), or (3) the currency that one of the parties uses as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary (see ASC 815-15-55-83 through 55-98).
-
Contracts that either require or periodically call for cash settlements of gains and losses (e.g., futures contracts) do not qualify for the exception (see ASC 815-10-15-36).
-
Option contracts and forward contracts with optionality features that can modify the volume to be delivered generally do not qualify for the NPNS scope exception (see ASC 815-10-15-40 and ASC 815-10-15-42 through 15-44). However, if power purchase or sales agreements (that are options, forwards, or a combination of both) are capacity contracts for the purchase or sale of electricity, they may still qualify for the NPNS scope exception if certain criteria are met (see ASC 815-10-15-45 through 15-51 and ASC 815-10-55-31).
-
For contracts that qualify for the exception, entities are required to provide documentation supporting the conclusion “that it is probable that the contract will not settle net and will result in physical delivery.” This documentation can be applied to groups of similarly designated contracts or to each individual contract. Entities should not apply the NPNS scope exception until such documentation is in place, even if all other criteria are met (see ASC 815-10-15-37 through 15-39).
-
The intent of the guidance is for the NPNS scope exception to be applied to entities whose operations include the use of the physical commodity, either in their productive operations or through physical distribution to their end customers. Thus, the concept of trading is not consistent with the concept of NPNS, and contracts that an entity designates as trading derivatives will not qualify for the NPNS scope exception in ASC 815.
Keep in mind that the NPNS scope exception is an election. That is, even if an
entity would qualify to apply the NPNS scope exception to its contracts, it
would typically not be required to do so. More specifically, ASC 815-10-15-39
states, “[t]he normal purchases and normal sales scope exception could
effectively be interpreted as an election in all cases.”
Further, even if an entity did not elect to apply the NPNS scope exception to a
contract at inception, it can still make the election on a future date as long
as it appropriately documents and supports the NPNS election at that time. In
that circumstance, the scope exception would apply prospectively from the
election date. The carrying amount of the derivative on the election date would
become the new cost basis of the contract, and the entity would apply other
appropriate U.S. GAAP to the contract prospectively. Further, all changes in the
fair value from contract inception through the election date would remain
recognized through earnings (i.e., it would be inappropriate to reverse such
amounts).
An entity should generally obtain the documentation for an NPNS contract by
consulting with, or surveying, the business groups that are familiar with the
entity’s contractual arrangements and the normal requirements of its business.
In the absence of such documentation, a contract that satisfies the criteria of
a derivative under ASC 815 and does not meet any of the other scope exceptions
should be accounted for as a derivative, even if the contract meets all of the
other criteria for the NPNS scope exception.
Although it is possible to elect to apply the NPNS scope exception after contract
inception, once an entity documents a contract as normal under ASC 815-10-15-22
through 15-51, it cannot change the designation to treat the contract as a
derivative unless the contract ceases to qualify for the exception. For example,
a contract would no longer qualify for the NPNS scope exception if delivery of
the underlying was no longer probable; in such a case, the contract should be
accounted for as a derivative asset or liability at its then current fair value,
with an offsetting entry to earnings. See the sections below for further
discussion of the NPNS requirements.
Example 2-2
NPNS Election for a Portion of Eligible
Contracts
Big City Bakery Company has 100
individual contracts to purchase wheat for use in its
operations. Each individual contract (1) satisfies the
criteria for a derivative under ASC 815, (2) contains a
provision that permits explicit net settlement, and (3)
would satisfy all of the criteria to qualify for the
NPNS scope exception, other than the required
documentation of the contracts as normal. Big City
Bakery wants to treat some of the contracts as
derivatives and to document some of the contracts as
normal. It is permitted under ASC 815 to simply choose
not to document some of the contracts as normal. In such
a case, the contracts that are documented as normal will
receive the scope exception and those that are not
documented as normal will be accounted for as
derivatives under ASC 815.
2.3.2.1 Normal Terms (Including Normal Quantity)
ASC 815-10
15-27 To
qualify for the scope exception, a contract’s terms
must be consistent with the terms of an entity’s
normal purchases or normal sales, that is, the
quantity purchased or sold must be reasonable in
relation to the entity’s business needs. Determining
whether or not the terms are consistent requires
judgment.
15-28 In
making those judgments, an entity should consider
all relevant factors, including all of the
following:
-
The quantities provided under the contract and the entity’s need for the related assets
-
The locations to which delivery of the items will be made
-
The period of time between entering into the contract and delivery
-
The entity’s prior practices with regard to such contracts.
15-29
Further, each of the following types of evidence
should help in identifying contracts that qualify as
normal purchases or normal sales:
-
Past trends
-
Expected future demand
-
Other contracts for delivery of similar items
-
An entity’s and industry’s customs for acquiring and storing the related commodities
-
An entity’s operating locations.
For guidance on normal purchases and normal sales as
hedged items, see paragraph 815-20-25-7.
When evaluating whether to use the NPNS scope exception, an entity should
consider whether the contract provides for the delivery or sale of an asset
in quantities that are expected to be used or sold by the entity over a
reasonable period in the normal course of business. The entity should
consider factors such as the following:
-
The quantities provided under the contract and the entity’s need for the related assets.3
-
The locations to which the items will be delivered.
-
The period between entering into the contract and the delivery.
-
The entity’s prior practices with regard to such contracts.
In addition, an entity should consider evidence such as past trends, expected
future demand for the items, other contracts for delivery of similar items,
the entity’s and industry’s customs for acquiring and storing the related
commodities, and the entity’s operating locations.
The factors noted above may not all apply to both parties to the contract. As
a result, the buyer and seller may reach different accounting conclusions
(e.g., although the seller may consider the quantity sold as normal, the
buyer may not consider it to be a quantity that will be used or sold in the
normal course of its business over a reasonable period).
Contracts that are entered into with the objective of generating profits from
market price changes are not eligible for the NPNS scope exception. Such an
objective is inconsistent with the concept that the quantities delivered
should be the expected quantities to be used or sold in the normal course of
business.
Example 2-3
Probable Delivery of an Asset Not
Used in an Entity’s Production, Manufacturing, or
Operations
A manufacturer enters into a contract to purchase
gold and asserts that it is probable that physical
delivery will be made. The manufacturer does not use
gold in its production, manufacturing, or other
operations. Therefore, the gold purchase contract
cannot be designated as a normal purchase because
the manufacturer will not use it in its normal
course of business. Similarly, if the manufacturer
had an operation that bought and sold gold on the
open market with the intent to speculate, trade, or
deal in gold, the forward contract could not be
designated as a normal purchase because trading
operations cannot qualify for the NPNS scope
exception.
2.3.2.2 Clearly-and-Closely-Related Underlying
ASC 815-10
15-30
Contracts that have a price based on an underlying
that is not clearly and closely related to the asset
being sold or purchased (such as a price in a
contract for the sale of a grain commodity based in
part on changes in the Standard and Poor’s index) or
that are denominated in a foreign currency that
meets none of the criteria in paragraph
815-15-15-10(b) shall not be considered normal
purchases and normal sales.
15-31 The
phrase not clearly and closely related in the
preceding paragraph with respect to the normal
purchases and normal sales scope exception is used
to convey a different meaning than in paragraphs
815-15-25-1(a) and 815-15-25-16 through 25-51 with
respect to the relationship between an embedded
derivative and the host contract in which it is
embedded. The guidance in this discussion of normal
purchases and normal sales does not affect the use
of the phrase not clearly and closely related
in paragraphs other than the preceding paragraph.
For purposes of determining whether a contract
qualifies for the normal purchases and normal sales
scope exception, the application of the phrase not
clearly and closely related to the asset being sold
or purchased shall involve an analysis of both
qualitative and quantitative considerations. The
analysis is specific to the contract being
considered for the normal purchases and normal sales
scope exception and may include identification of
the components of the asset being sold or
purchased.
15-32 The
underlying in a price adjustment incorporated into a
contract that otherwise satisfies the requirements
for the normal purchases and normal sales scope
exception shall be considered to be not clearly and
closely related to the asset being sold or purchased
in any of the following circumstances:
-
The underlying is extraneous (that is, irrelevant and not pertinent) to both the changes in the cost and the changes in the fair value of the asset being sold or purchased, including being extraneous to an ingredient or direct factor in the customary or specific production of that asset.
-
If the underlying is not extraneous as discussed in (a), the magnitude and direction of the impact of the price adjustment are not consistent with the relevancy of the underlying. That is, the magnitude of the price adjustment based on the underlying is significantly disproportionate to the impact of the underlying on the fair value or cost of the asset being purchased or sold (or of an ingredient or direct factor, as appropriate).
-
The underlying is a currency exchange rate involving a foreign currency that meets none of the criteria in paragraph 815-15-15-10(b) for that reporting entity.
15-33 For
example, in the case in which the price adjustment
focuses on the changes in the fair value of the
asset being purchased or sold, if the terms of the
price adjustment are expected, at the inception of
the contract, to affect the purchase or sales price
in a manner comparable to the outcome that would be
obtained if, at each delivery date, the parties were
to reprice the contract amount under the
then-existing conditions for the asset being
delivered on that date, the price adjustment’s
underlying is considered to be clearly and closely
related to the asset being sold or purchased and the
price adjustment would not be an impediment to the
contract qualifying for the normal purchases and
normal sales scope exception.
15-34 If the
underlying in a price adjustment incorporated into a
purchase or sales contract is not an impediment to
qualifying for the normal purchases and normal sales
scope exception because it is considered to be
clearly and closely related to the asset being sold
or purchased, the contract must meet the other
requirements in this Subsection to qualify for the
normal purchases and normal sales scope
exception.
For a contract to qualify for the NPNS scope exception, ASC 815-10-15-30
requires, among other things, that the price of the contract not be “based
on an underlying that is not clearly and closely related to the asset being
sold or purchased.” ASC 815-10-15-31 through 15-34 provide interpretations
of what “clearly and closely related” means in the context of the NPNS scope
exception.
Under ASC 815-10-15-31 through 15-34, “application of the phrase not clearly
and closely related to the asset being sold or purchased shall involve an
analysis of both qualitative and quantitative considerations.” Such
analysis, which must be performed only at the inception of contract, “is
specific to the contract being considered for the normal purchases and
normal sales scope exception and may include identification of the
components of the asset being sold or purchased.” ASC 815-10-15-32 notes
three circumstances in which the underlying in a “price adjustment”
incorporated into a contract would be considered to be “not clearly and
closely related to the asset being sold or purchased,” thereby preventing
the contract from qualifying for the NPNS scope exception:
-
The underlying is extraneous (that is, irrelevant and not pertinent) to both the changes in the cost and the changes in the fair value of the asset being sold or purchased, including being extraneous to an ingredient or direct factor in the customary or specific production of that asset.
-
If the underlying is not extraneous . . . , the magnitude and direction of the impact of the price adjustment are not consistent with the relevancy of the underlying. That is, the magnitude of the price adjustment based on the underlying is significantly disproportionate to the impact of the underlying on the fair value or cost of the asset being purchased or sold (or of an ingredient or direct factor, as appropriate).
-
The underlying is a currency exchange rate involving a foreign currency that meets none of the criteria in paragraph 815-15-15-10(b) for that reporting entity.
Accordingly, if a finished product made from raw material does not fall into
any of the three categories described in ASC 815-10-15-32 above, the
contract to purchase or sell the raw material may qualify for the NPNS scope
exception if it meets the other requirements in ASC 815-10-15-22 through
15-51.
2.3.2.3 Probable Physical Settlement
ASC 815-10
15-35 For a
contract that meets the net settlement provisions of
paragraphs 815-10-15-100 through 15-109 and the
market mechanism provisions of paragraphs
815-10-15-110 through 15-118 to qualify for the
normal purchases and normal sales scope exception,
it must be probable at inception and throughout the
term of the individual contract that the contract
will not settle net and will result in physical
delivery.
15-36 The
normal purchases and normal sales scope exception
only relates to a contract that results in gross
delivery of the commodity under that contract. The
normal purchases and normal sales scope exception
shall not be applied to a contract that requires
cash settlements of gains or losses or otherwise
settle gains or losses periodically because those
settlements are net settlements. Paragraph
815-20-25-22 explains how an entity may designate
such a contract as a hedged item in an all-in-one
hedge if all related criteria are met.
15-36A
Certain contracts for the purchase or sale of
electricity on a forward basis that necessitate
transmission through, or delivery to a location
within, an electricity grid operated by an
independent system operator result in one of the
contracting parties incurring charges (or credits)
for the transmission of that electricity based in
part on locational marginal pricing differences
payable to (or receivable from) the independent
system operator. For example, this is the case when
the delivery location under the contract (for
example, a hub location) is not the same location as
the point of ultimate consumption of the electricity
or the point from which the electricity exits the
electricity grid for transmission to a customer load
zone. Delivery to the point of ultimate consumption
or the exit point is facilitated by the independent
system operator of the grid. The purchase or sale
contract and the transmission services do not
constitute a series of sequential contracts intended
to accomplish the ultimate acquisition or sale of a
commodity as discussed in paragraph 815-10-15-41,
and the use of locational marginal pricing to
determine the transmission charge (or credit) does
not constitute net settlement, even in situations in
which legal title to the associated electricity is
conveyed to the independent system operator during
transmission.
If a contract permits contractual net settlement or there is a market
mechanism to facilitate net settlement, both of the following must be
probable at inception and throughout the term of the individual contract for
it to qualify for the NPNS scope exception:
-
The contract will not net settle.
-
The contract will result in physical delivery.
The NPNS scope exception is not available for contracts that require cash
settlements of gains or losses or that otherwise settle gains or losses on a
periodic basis.
Aside from certain capacity contracts (see further discussion in Section 2.3.2.6.4), contracts that are
subject to unplanned netting (i.e., “bookouts”) do not qualify for the NPNS
scope exception even if an entity can conclude that physical delivery is
probable.
An entity is required to assess, on an ongoing basis, whether it is probable
that a contract will result in physical delivery and will not net settle. A
net settlement of one contract may cause similar contracts to not be
eligible for the exception.
Example 2-4
Exchange-for-Physical Arrangements
In January 20X1, Natural Fabrics Co. enters into a
futures contract to buy cotton to hedge the
anticipated purchase of cotton for its fabric
production planned for December 20X1. In the cotton
industry, brokers are generally unwilling to enter
into forward delivery contracts before the given
year’s cotton crop has been planted unless the buyer
pays a significant premium. However, futures
contracts can be used to cover these longer periods.
Futures contracts do not qualify for the NPNS scope
exception, so Natural Fabrics Co. designates the
contract it entered into as a cash flow hedge of the
forecasted purchase of cotton in December because
all the requirements for a cash flow hedge are
met.
In May, when the acreage of cotton planted is known
and weather patterns are forecasted, brokers are
willing to enter into fixed-price forward contracts
to sell cotton without significant premiums.
Consequently, Natural Fabrics Co. assigns its rights
and obligations under the futures contract to a
broker, who “steps into” Natural Fabrics Co.’s
position and simultaneously enters into a forward
contract with Natural Fabrics Co. for the delivery
of cotton in December. Since the price of cotton has
increased between January and May, the futures
contract has a positive fair value. The inherent
gain in the contract is assumed by the broker, and
Natural Fabrics Co. receives no cash premium from
the broker. However, the price under the fixed-price
forward agreement is adjusted so that the forward
contract has a positive fair value equal to the fair
value of the futures contract surrendered.
Arrangements in which a futures contract is
exchanged for a forward contract are typically
called exchange-for-physical arrangements.
The forward contract that Natural Fabrics Co.
purchases in May could qualify for the NPNS scope
exception, even though it is not entered into at
market, if it meets the criteria for a normal
purchase contract as specified in ASC 815-10-15-22
through 15-51. To qualify for the NPNS scope
exception, Natural Fabrics Co. needs to assert that
the delivery of cotton under the forward contract is
probable.
2.3.2.4 Net Settlement of a Contract to Which the NPNS Scope Exception Is Applied
The net settlement of a normal contract does not necessarily taint the
designation of a company’s other normal contracts. ASC 815-10-15-41 states
that “[n]et settlement . . . of contracts in a group of contracts similarly
designated as normal purchases and normal sales would call into question the
classification of all such contracts as normal purchases or normal sales.”
Each time a company net settles a normal contract, it must consider how the
facts and circumstances that resulted in net settlement (and any prior net
settlements) affect the assertion that physical delivery under similar
contracts is still probable.
For example, assume that a power supply company does not deliver on a normal
delivery contract because its power plant was down for a day after a small
fire. Such an occurrence would probably not affect the designation of the
company’s other normal delivery contracts for the next month. However, if
the power supply company net settled a normal contract at a significant gain
to take advantage of a favorable change in the price of electricity, that
would probably call into question its intent to deliver under similar
contracts.
Example 2-5
NPNS Election When Assets Are Immediately
Sold
SnackFood Company has a series of normal fixed-price
forward contracts to purchase rice, which is used in
the production of the rice cakes it sells. The
forward contracts meet the definition of a
derivative as well as the RCC criteria in ASC
815-10-15-119, but they do not meet the other net
settlement criteria (i.e., no explicit net
settlement, no market mechanism). SnackFood takes
delivery of the rice and immediately sells it on the
spot market instead of using it in its operations.
The NPNS scope exception is available for contracts
that provide for the delivery of an asset that is
expected to be used by an entity over a reasonable
period in the normal course of business. SnackFood
effectively used the spot market to net settle the
forward contracts. It should now consider how the
net settlement of these normal purchase contracts
affects the designation of similar normal
contracts.
Example 2-6
NPNS Election and Changes in Anticipated Use of
Assets
Bluebread Company has a series of normal fixed-price
contracts to purchase wheat from Wheat Farmco. Wheat
is an ingredient used in the production of the bread
that Bluebread sells. The contracts meet the
definition of a derivative as well as the RCC
criteria in ASC 815-10-15-119, but they do not meet
the other net settlement criteria (i.e., no explicit
net settlement, no market mechanism). Before
delivery under the contracts is scheduled,
Bluebread’s employees go on strike. Bluebread does
not need the monthly shipment of wheat, so it enters
into a forward contract to sell the wheat to
HealthyBakery and arranges for Wheat Farmco to
deliver the wheat directly to HealthyBakery.
However, Bluebread is not relieved of its rights and
obligations under the forward purchase contract with
Wheat Farmco. Bluebread must pay Wheat Farmco the
full amount under the purchase contract, and
HealthyBakery must pay Bluebread the full amount
under the sale contract.
The NPNS scope exception is available for contracts
that provide for the delivery of an asset that is
expected to be used by an entity over a reasonable
period in the normal course of business. Even though
Bluebread did not explicitly net settle the forward
contract with Wheat Farmco, it did not take delivery
of the wheat. At the time it entered into the
forward sale agreement with HealthyBakery, Bluebread
could no longer support the assertion that delivery
of the wheat under the normal purchase contract with
Wheat Farmco was probable. Therefore, the contract
would need to be dedesignated as “not normal” and
accounted for as a derivative under ASC 815.
Bluebread should also consider how the net
settlement of this normal purchase contract affects
the designation of similar normal contracts.
In addition, the forward sales contract with
HealthyBakery would not qualify for the normal sales
exception because Bluebread does not sell wheat as
part of its normal operations.
2.3.2.5 Documentation
ASC 815-10
15-37 For
contracts that qualify for the normal purchases and
normal sales exception under any provision of
paragraphs 815-10-15-22 through 15-51, the entity
shall document the designation of the contract as a
normal purchase or normal sale, including either of
the following:
-
For contracts that qualify for the normal purchases and normal sales exception under paragraph 815-10-15-41 or 815-10-15-42 through 15-44, the entity shall document the basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.
-
For contracts that qualify for the normal purchases and normal sales exception under paragraphs 815-10-15-45 through 15-51, the entity shall document the basis for concluding that the agreement meets the criteria in that paragraph, including the basis for concluding that the agreement is a capacity contract.
15-38 The
documentation requirements can be applied either to
groups of similarly designated contracts or to each
individual contract. Failure to comply with the
documentation requirements precludes application of
the normal purchases and normal sales scope
exception to contracts that would otherwise qualify
for that scope exception.
15-39 The
normal purchases and normal sales scope exception
could effectively be interpreted as an election in
all cases. However, once an entity documents
compliance with the requirements of paragraphs
815-10-15-22 through 15-51, which could be done at
the inception of the contract or at a later date,
the entity is not permitted at a later date to
change its election and treat the contract as a
derivative instrument.
In the event that an entity elects to apply the NPNS scope exception for a
qualifying contract, it should document the designation of the contract as
NPNS, including either of the following:
-
Its basis for concluding that it is probable that the contract will not settle net and will result in physical delivery.
-
Its basis for concluding that the agreement meets the criteria in ASC 815-10-15-43 through 15-51 (see Section 2.3.2.6), including the basis for concluding that the agreement is a capacity contract.
It is possible to apply the documentation requirements either to groups of
similarly designated contracts or to each individual contract. If the
documentation requirements are not met, the NPNS scope exception cannot be
applied to a contract that would otherwise qualify for the NPNS scope
exception.
2.3.2.6 Applicability of the NPNS Scope Exception to Specific Types of Contracts
To help entities determine whether a contract is eligible for the NPNS scope
exception, ASC 815 distinguishes between options, forward contracts, and
forward contracts with optionality.
2.3.2.6.1 Freestanding Option Contracts
ASC 815-10
15-26
Also discussed is guidance that should be
considered in determining whether each of the
following specific types of contracts qualifies
for the normal purchases and normal sales scope
exception:
-
Freestanding option contracts
-
Forward (non-option-based) contracts
-
Forward contracts that contain optionality features
-
Power purchase or sale agreements.
15-40
Option contracts that would require delivery of
the related asset at an established price under
the contract only if exercised are not eligible to
qualify for the normal purchases and normal sales
scope exception, except as indicated in paragraphs
815-10-15-45 through 15-51.
Option contracts are not eligible for this scope exception unless they
are capacity contracts that meet certain criteria (see Section
2.3.2.6.4). Because of the nature of option contracts, an
entity cannot determine at the inception of the contract that it will be
probable throughout the contract’s term that physical delivery under
that specific contract will occur.
2.3.2.6.2 Forward Contracts
ASC 815-10
15-41
Forward contracts are eligible to qualify for the
normal purchases and normal sales scope exception.
However, forward contracts that contain net
settlement provisions as described in either
paragraphs 815-10-15-100 through 15-109 or
815-10-15-110 through 15-118 are not eligible for
the normal purchases and normal sales scope
exception unless it is probable at inception and
throughout the term of the individual contract
that the contract will not settle net and will
result in physical delivery. Contracts that are
subject to unplanned netting (referred to as a
book-out in the electric utility industry) do not
qualify for this scope exception except as
specified in paragraph 815-10-15-46. Net
settlement (as described in paragraphs
815-10-15-100 through 15-109 and 815-10-15-110
through 15-118) of contracts in a group of
contracts similarly designated as normal purchases
and normal sales would call into question the
classification of all such contracts as normal
purchases or normal sales. Contracts that require
cash settlements of gains or losses or are
otherwise settled net on a periodic basis,
including individual contracts that are part of a
series of sequential contracts intended to
accomplish ultimate acquisition or sale of a
commodity, do not qualify for the normal purchases
and normal sales scope exception.
Forward contracts for a quantity that is expected to be
used or sold by the entity over a reasonable period in the normal course
of business generally qualify for the NPNS scope exception; however, a
contract that contains net settlement provisions as described in either
ASC 815-10-15-100 through 15-109 or ASC 815-10-15-110 through 15-118
would only qualify for the NPNS scope exception if it is probable at
inception and throughout the term of the individual contract that the
contract will not settle net and will result in physical delivery.
2.3.2.6.3 Forward Contracts That Contain Optionality Features
ASC 815-10
15-42
Forward contracts that contain optionality
features that do not modify the quantity of the
asset to be delivered under the contract are
eligible to qualify for the normal purchases and
normal sales scope exception. Except for power
purchase or sales agreements addressed in
paragraphs 815-10-15-45 through 15-51, if an
option component permits modification of the
quantity of the assets to be delivered, the
contract is not eligible for the normal purchases
and normal sales scope exception, unless the
option component permits the holder only to
purchase or sell additional quantities at the
market price at the date of delivery. For forward
contracts that contain optionality features to
qualify for the normal purchases and normal sales
scope exception, the criteria discussed in the
preceding paragraph must be met.
15-43 If
the optionality feature in the forward contract
can modify the quantity of the asset to be
delivered under the contract and that option
feature has expired or has been completely
exercised (even if delivery has not yet occurred),
there is no longer any uncertainty as to the
quantity to be delivered under the forward
contract. Accordingly, following such expiration
or exercise, the forward contract would be
eligible for designation as a normal purchase or
normal sale, provided that the other applicable
conditions in this Subsection are met. Example 10
(see paragraph 815-10-55-121) illustrates this
guidance.
15-44 The
inclusion of a purchased option that would, if
exercised, require delivery of the related asset
at an established price under the contract within
a single contract that meets the definition of a
derivative instrument disqualifies the entire
contract from being eligible to qualify for the
normal purchases and normal sales scope exception
in this Subsection except as provided in the
following paragraph through paragraph 815-10-15-51
with respect to certain power purchase or sales
agreements.
Forward purchase and sale contracts may include optionality, including
optionality related to the price or quantity to be purchased or sold.
Pricing optionality does not generally prevent a contract from being
eligible for the NPNS scope exception. If, however, the pricing
optionality is attributable to a price adjustment clause based on an
underlying that is unrelated to the asset to be delivered, the contract
may not qualify for the NPNS scope exception.
By contrast to pricing optionality, optionality related to quantity may
cause a contract to be ineligible for the NPNS scope exception. However,
a forward contract that requires the purchase of a specified quantity at
an established price but also provides the option of purchasing
additional quantities at the market price on the date of delivery is
eligible for the NPNS scope exception.
There is a limited exception for certain electricity contracts held by
utilities (see ASC 815-10-15-45 through 15-51 and ASC 815-10-55-31).
Example 2-7
Option Contracts and the NPNS Scope
Exception
A manufacturer enters into a
contract to buy a fixed quantity of 10,000 gallons
of heating oil from its local supplier each month
at a fixed price for the next two years. The
contract gives the manufacturer an option to
increase the quantity to 12,000 gallons each month
at a fixed price. The existence of the embedded
purchase option disqualifies the entire instrument
from being eligible for the NPNS scope exception
since the option permits modification of the
quantity of the assets to be delivered.
ASC 815-10-15-40 states that option contracts cannot qualify for the NPNS
scope exception. Further, as indicated in ASC 815-10-15-42 through
15-44, if a forward contract includes any embedded volumetric options
(i.e., options that provide for the purchase or sale of additional units
at a fixed price), the entire forward contract may be disqualified from
being considered normal. Bifurcation of the forward and option
components of the contract is not permitted under the guidance in ASC
815-15-15-4 and ASC 815-10-55-24 through 55-30. Therefore, because (1)
an option cannot qualify as a normal purchase under ASC 815-10-15-40 and
(2) the instrument cannot be bifurcated into components, the entire
instrument must be accounted for as a derivative under ASC 815.
ASC 815-10-15-9 prohibits an entity from structuring an arrangement to
circumvent the provisions of ASC 815 through multiple separate
transactions. However, ASC 815-10-55-27 creates an exception to this
principle for the application of the NPNS scope exception to an
arrangement involving optional purchases. That is, this paragraph
indicates that an entity can enter into two distinct contracts — a
forward contract and an option contract — that achieve the same economic
outcome as a single contract. This exception allows the forward contract
to potentially qualify for the NPNS scope exception, subject to meeting
other requirements of ASC 815; in such case, only the freestanding
option would be accounted for as a derivative. This concept is further
elaborated in ASC 815-10-55-30.
ASC 815-10
55-27 An
entity may wish to enter into two separate
contracts — a forward contract and an option —
that economically achieve the same results as the
single derivative instrument and determine whether
the normal purchases and normal sales scope
exception (as discussed beginning in paragraph
815-10-15-22) applies to the separate forward
contract.
55-30 If
an entity’s single supply contract included at its
inception both a forward contract and an option
and, in subsequent renegotiations, that contract
is negated and replaced by two separate contracts
(a forward contract for a specific quantity that
will be purchased and an option for additional
quantities whose purchase is conditional upon
exercise of the option), the new forward contract
would be eligible to qualify for the normal
purchases and normal sales exception (as discussed
beginning in paragraph 815-10-15-22), whereas the
new option would not be eligible for that
exception. From its inception the new separate
option would be accounted for under this
Subtopic.
Given this guidance, if the entity in Example 2-7
wanted to avoid treating the entire option contract as a derivative, it
could structure the transaction in two separate contracts: (1) a forward
to meet its expected needs and (2) an option contract to meet any
forecasted but less certain needs. In this case, the forward contract
may qualify as a normal purchase and only the purchased option would be
accounted for as a derivative. In addition, as noted in ASC
815-10-15-42, a contract may qualify for the NPNS scope exception if the
option contract (or component of a contract) only permits the holder to
purchase or sell additional quantities at the market price on the
delivery date.
The preclusion from qualifying for the NPNS scope exception for forward
contracts with embedded optionality that may affect the quantity to be
delivered does not necessarily apply to all such contracts. Therefore,
the forward component and option component of a contract still must be
analyzed under the provisions of ASC 815 to determine whether each
component meets the definition of a derivative. A forward component or
embedded option component of the contract may or may not contain a
notional amount4 if either component is a requirements contract, as noted in ASC
815-10-55-5 through 55-7. For example, the contract may be similar to
contract 3 in ASC 815-10-55-5 (see Section
1.4.1.2.1), in which the buyer must purchase a minimum of
60 units (the forward component) and has an option to purchase as many
units as needed above 60 to satisfy its actual needs. In such a
contract, the forward component does have a notional amount and may meet
the definition of a derivative. Evaluation of the option component
should include consideration of whether this component contains a
notional amount. ASC 815-10-15-92 states, in part, that “a requirements
contract [that] contains explicit provisions that support the
calculation of a determinable amount reflecting the buyer’s needs . . .
has a notional amount.” Explicit provisions include estimated volumes
specified in the contract related to default provisions, since these
default provisions may refer to determinable amounts such as anticipated
quantities or average historical use quantities that will give the
contract a notional amount. If a notional amount does not exist
because of the lack of “explicit provisions,” the contract, in its
entirety, may qualify for the NPNS scope exception.
The FASB implementation guidance below illustrates the concepts discussed
above.
ASC 815-10
Example 10: Normal Purchases and Normal
Sales — Application to Forward Contracts That
Contain Optionality Features
55-121 In
some circumstances, an option may be combined with
a forward contract. In some instances, the
optionality feature in the forward contract can
modify the quantity of the asset to be delivered
under the contract. In other cases, the
optionality feature in the forward contract can
modify only the price to be paid or the timing of
the delivery.
55-122
This Example presents three Cases of forward
contracts with optionality features:
-
Optionality feature involving price floor (cash-settled put option) written by purchaser and price cap (cash-settled call option) written by seller (Case A)
-
Optionality feature involving cash-settled put option written by purchaser (Case B)
-
Optionality feature involving physically settled put option written by purchaser (Case C).
55-123 In
Cases A, B, and C, the optionality feature must be
analyzed to determine whether it could modify the
quantity of the asset to be delivered under the
contract. In doing so, the conclusion as to
whether the contract is eligible for the normal
purchases and normal sales scope exception applies
in the same way to both counterparties — the
purchaser and the writer of the option (within the
forward contract).
55-124
The contracts addressed in this Example do not
have a price based on an underlying that is not
clearly and closely related to the asset being
purchased, nor do they require cash settlement of
gains or losses as stipulated in paragraph
815-10-15-22.
55-125
Paragraph 815-10-15-43 explains that, if the
optionality feature in the forward contract can
modify the quantity of the asset to be delivered
under the contract, but that option feature has
expired or has been completely exercised (even if
delivery has not yet occurred), there is no longer
any uncertainty as to the quantity to be delivered
under the forward contract. That paragraph
explains that, following such expiration or
exercise, the forward contract would be eligible
for designation as a normal purchase or normal
sale, provided that the other conditions in
paragraph 815-10-15-22 are met.
Case A: Optionality Feature Involving Price Floor
(Cash-Settled Put Option) Written by Purchaser and
Price Cap (Cash-Settled Call Option) Written by
Seller
55-126
Entity A enters into a forward contract to
purchase on a specified date a specified quantity
of a raw material that is readily convertible to
cash. The purchase price is the current market
price on the date of purchase, not to exceed a
specified maximum price (a cap) nor to be less
than a specified minimum price (a floor).
55-127 In
this Case, the optionality feature cannot modify
the quantity to be delivered; thus, the contract
is eligible to qualify for the normal purchases
and normal sales scope exception.
Case B: Optionality Feature Involving
Cash-Settled Put Option Written by Purchaser
55-128
Entity B enters into a forward contract to
purchase on a specified date a specified quantity
of a raw material that is readily convertible to
cash. The contract’s purchase price is a fixed
amount per unit that is below the current forward
price; however, if the market price on the date of
purchase has fallen below a specified level,
Entity B’s purchase price would be adjusted to a
higher fixed amount significantly in excess of the
current forward price at the inception of the
contract. (The contract entered into by Entity B
is a compound derivative consisting of a forward
contract to purchase raw material at the original
fixed price and a written option that obligates
Entity B to purchase the raw material for the
higher adjusted price if the market price of the
raw material falls below the specified level. In
exchange for the written option, Entity B received
a premium representing the difference between the
purchase price in the contract and the forward
market price of the raw material at the inception
of the contract.)
55-129
The forward purchase contract in this Case is
eligible to qualify for the normal purchases and
normal sales scope exception because the
optionality feature in the contract cannot modify
the quantity to be delivered.
Case C: Optionality Feature Involving Physically
Settled Put Option Written by Purchaser
55-130
Entity C enters into a forward contract to
purchase on a specified date a specified quantity
of a raw material that is readily convertible to
cash. The contract’s purchase price is a fixed
amount per unit that is below the current forward
price. However, if the market price on the date of
purchase has fallen below a specified level that
is below the contract’s fixed purchase price,
Entity C would be required to purchase a specified
additional quantity of the raw material at the
contract’s fixed purchase price (which is above
the current market price on the date of purchase).
(The contract entered into by Entity C is a
compound derivative consisting of a forward
contract to purchase raw material at the original
fixed price and a written option that obligates
Entity C to purchase additional quantities of the
raw material at an above-market price if the
market price of the raw material falls below the
specified level.)
55-131
The contract in this Case is not eligible to
qualify for the normal purchases and normal sales
scope exception because the optionality feature in
the contract can modify the quantity of the asset
to be delivered under the contract.
2.3.2.6.4 Capacity Contracts
ASC 815-10
15-45
Notwithstanding the criteria in paragraphs
815-10-15-41 through 15-44, a power purchase or
sales agreement (whether a forward contract,
option contract, or a combination of both) that is
a capacity contract for the purchase or sale of
electricity also qualifies for the normal
purchases and normal sales scope exception if all
of the following applicable criteria are met:
- For both parties to the
contract, both of the following criteria are
met:
-
The terms of the contract require physical delivery of electricity. That is, the contract does not permit net settlement, as described in paragraphs 815-10-15-100 through 15-109. For an option contract, physical delivery is required if the option contract is exercised. Certain contracts for the purchase or sale of electricity on a forward basis that necessitate transmission through, or delivery to a location within, an electricity grid operated by an independent system operator result in one of the contracting parties incurring charges (or credits) for the transmission of that electricity based in part on locational marginal pricing differences payable to (or receivable from) the independent system operator. For example, this is the case when the delivery location under the contract (for example, a hub location) is not the same location as the point of ultimate consumption of the electricity or the point from which the electricity exits the electricity grid for transmission to a customer load zone. Delivery to the point of ultimate consumption or the exit point is facilitated by the independent system operator of the grid. The use of locational marginal pricing to determine the transmission charge (or credit) does not constitute net settlement, even in situations in which legal title to the associated electricity is conveyed to the independent system operator during transmission.
-
The power purchase or sales agreement is a capacity contract. Differentiating between a capacity contract and a traditional option contract (that is, a financial option on electricity) is a matter of judgment that depends on the facts and circumstances. For power purchase or sale agreements that contain option features, the characteristics of an option contract that is a capacity contract and a traditional option contract, which are set forth in paragraph 815-10-55-31 shall be considered in that evaluation; however, other characteristics not listed in that paragraph may also be relevant to that evaluation.
-
-
For the seller of electricity: The electricity that would be deliverable under the contract involves quantities that are expected to be sold by the reporting entity in the normal course of business.
-
For the buyer of electricity, all of the following criteria are met:
-
The electricity that would be deliverable under the contract involves quantities that are expected to be used or sold by the reporting entity in the normal course of business.
-
The buyer of the electricity under the power purchase or sales agreement is an entity that meets both of the following criteria:
-
The entity is engaged in selling electricity to retail or wholesale customers.
-
The entity is statutorily or otherwise contractually obligated to maintain sufficient capacity to meet electricity needs of its customer base.
-
- The contracts are entered into to meet the buyer’s obligation to maintain a sufficient capacity, including a reasonable reserve margin established by or based on a regulatory commission, local standards, regional reliability councils, or regional transmission organizations.
-
15-46
Power purchase or sales agreements that meet only
the applicable criteria in paragraph 815-10-15-45
qualify for the normal purchases and normal sales
scope exception even if they are subject to being
booked out or are scheduled to be booked out.
15-47
Forward contracts for the purchase or sale of
electricity that do not meet those applicable
criteria as well as other forward contracts are
nevertheless eligible to qualify for the normal
purchases and normal sales scope exception by
meeting the criteria in this Subsection (other
than paragraph 815-10-15-45), unless those
contracts are subject to unplanned netting (that
is, subject to possibly being booked out).
15-48
Because electricity cannot be readily stored in
significant quantities and the entity engaged in
selling electricity is obligated to maintain
sufficient capacity to meet the electricity needs
of its customer base, an option contract for the
purchase of electricity that meets the criteria in
paragraph 815-10-15-45 qualifies for the normal
purchases and normal sales scope exception in that
paragraph.
15-49
This guidance does not affect the accounting for
requirements contracts that would not be required
to be accounted for under the guidance in this
Subtopic pursuant to paragraphs 815-10-55-5
through 55-7.
15-50
Contracts that qualify for the normal purchases
and normal sales scope exception based on this
guidance do not require compliance with any
additional guidance in paragraphs 815-10-15-22
through 15-44. However, contracts that have a
price based on an underlying that is not clearly
and closely related to the electricity being sold
or purchased or that are denominated in a foreign
currency that meets none of the criteria in
paragraph 815-15-15-10(b) shall not be considered
normal purchases and normal sales.
15-51
This guidance shall not be applied by analogy to
the accounting for other types of contracts not
meeting the stated criteria.
55-31 The
following table lists characteristics of an option
that is a capacity contract and a traditional
option. The characteristics listed may be relevant
to the application of paragraph
815-10-15-45(a)(2). Other characteristics not
listed may also be relevant.
Option Contract That Is a Capacity Contract
|
Financial Option Contract on Electricity
|
---|---|
1 The contract usually specifies the power
plant or group of power plants providing the
electricity.
|
No reference is made to the generation
origination of the electricity.
|
2 The strike price (paid upon exercise)
includes pricing terms to compensate the plant
operator for variable operations and maintenance
costs expected during the specified production
periods.
|
The strike price is structured based on the
expected forward prices of power.
|
3 The specified quantity is based on individual
needs of parties to the agreement.
|
The specified quantity reflects standard
amounts of electric energy, which facilitate
market liquidity (for example, exercise in
increments of 10,000 kilowatt-hours).
|
4 The title transfer point is usually at one or
a group of specified physical delivery point(s),
as opposed to a major market hub.
|
The specified index transfer point is a major
market hub (liquid trading hub), not seller- or
buyer-site specific.
|
5 The contract usually specifies certain
operational performance by the facility (for
example, the achievement of a certain heat
rate).
|
No operational performance is specified (not
plant specific).
|
6 The contract sometimes incorporates
requirements for interconnection facilities,
physical transmission facilities, or reservations
for transmission services.
|
None specified.
|
7 The contract may specify jointly agreed-to
plant outages (for example, for maintenance) and
provide for penalties in the event of unexpected
outages.
|
Penalties for outages are not specified (not
plant specific).
|
8 Damage provisions upon default are usually
based on a reduction of the capacity payment
(which is not market based). If default provisions
specify market liquidating damages, they usually
contain some form of floor, ceiling, or both. The
characteristics of the default provision are
usually tied to the expected generation
facility.
|
Damage provisions upon default are based on
market liquidating damages.
|
9 The contract’s term is usually long (one year
or more).
|
The contract’s term is not longer than 18 to 24
months because financial options on electricity
are currently illiquid beyond that period.
|
ASC 815-10-15-45 through 15-51 and ASC 815-10-55-31 clarify the
application of the NPNS scope exception specifically to capacity
contracts for the purchase or sale of electricity (i.e., power purchase
and sale contracts). In providing such guidance, the FASB acknowledged
the unique nature of arrangements in that industry.
For example, electricity cannot be readily stored in significant
quantities; however, electricity suppliers are often obligated to
maintain a specified level of electricity supply to meet demand. As a
result, some contracts to buy and sell electricity give the buyer some
flexibility in determining when to take delivery of electricity and in
what quantities to match the fluctuating demand for power.
In accordance with ASC 815-10-15-45, regardless of whether an agreement
includes optionality features that can modify the quantity under the
contract (i.e., even if the agreement does not meet the criteria in ASC
815-10-15-22 through 15-44), an entity is permitted to apply the NPNS
scope exception to a capacity contract for the purchase or sale of
electricity5 if the following conditions are met:
-
“The power purchase or sales agreement is a capacity contract” (see below).
-
“The terms of the contract require physical delivery of electricity.”
-
“For the seller of electricity: the electricity that would be deliverable under the contract involves quantities that are expected to be sold by the reporting entity in the normal course of business.”
-
For the buyer of electricity:
-
“The electricity that would be deliverable under the contract involves quantities that are expected to be used or sold by the reporting entity in the normal course of business.”
-
“The entity is engaged in selling electricity to retail or wholesale customers” and “[t]he entity is statutorily or otherwise contractually obligated to maintain sufficient capacity to meet electricity needs of its customer base.”
-
“The contracts are entered into to meet the buyer’s obligation to maintain a sufficient capacity, including a reasonable reserve margin established by or based on a regulatory commission, local standards, regional reliability councils, or regional transmission organizations.”
-
ASC 815-10-20 defines a capacity contract as an “agreement by an owner of
capacity to sell the right to that capacity to another party so that it
can satisfy its obligations. For example, in the electric industry,
capacity (sometimes referred to as installed capacity) is the capability
to deliver electric power to the electric transmission system of an
operating control area.” The characteristics listed in ASC 815-10-55-31
above should be used to determine whether an option contract or a
forward contract with option features meets the definition of a capacity
contract. Therefore, an entity should consider different criteria in
determining whether a firm forward contract (i.e., a forward contract
without option features) meets the definition of a capacity
contract.
2.3.2.6.5 Firm Forward Power Purchase and Sale Contract That Is Subject to Unplanned Netting
A firm forward power purchase and sale contract that is subject to
unplanned netting may qualify for the NPNS scope exception if it meets
the criteria in ASC 815-10-15-45 through 15-51. While an entity can
consider the characteristics in ASC 815-10-55-31 to help determine
whether an option contract meets the definition of a capacity contract
(which is one criterion in ASC 815-10-15-45(a)(2)), ASC 815-10-55-31 is
not relevant to firm forward contracts because it only applies to
contracts with option features. For forward contracts, entities should
look to the definition of a capacity contract in ASC 815-10-20. In
addition, they may consider the criteria below when applying that
definition to a forward contract subject to unplanned netting to
determine whether it qualifies for the NPNS scope exception.
The following criteria are applicable to the purchaser, as indicated in
ASC 815-10-15-45 through 15-51:
-
“The terms of the contract require physical delivery of electricity. That is, the contract does not permit net settlement, as described in paragraphs 815-10-15-100 through 15-109.”
-
“The electricity that would be deliverable under the contract involves quantities that are expected to be used or sold by the reporting entity in the normal course of business.” Under this criterion, if the quantities purchased exceed the purchaser’s obligations, including load and reserve capacity requirements, they could not be designated as normal by the purchaser.
-
“The buyer of the electricity under the power purchase or sales agreement is an entity that . . . is engaged in selling electricity to retail or wholesale customers [and] is statutorily or otherwise contractually obligated to maintain sufficient capacity to meet electricity needs of its customer base.”
-
“The contracts are entered into to meet the buyer’s obligation to maintain a sufficient capacity, including a reasonable reserve margin established by or based on a regulatory commission, local standards, regional reliability councils, or regional transmission organizations.” This criterion would not be met if the purchaser was buying more than is needed to serve estimated obligations (including load requirements and contractual obligations), when compared with existing generating capacity and other purchase contracts.
-
“The power purchase or sales agreement is a capacity contract. Differentiating between a capacity contract and a traditional [forward] contract (that is, a financial [forward] on electricity) is a matter of judgment that depends on the facts and circumstances.” For a forward contract to qualify as a capacity contract, both of the following criteria must be met:
-
The purchaser is buying the amount that meets its obligation (same as criterion 4 above).
-
The seller has the capacity to back the contract.To meet this criterion, the contract does not have to specify the source of the power. However, the buyer must have evidence (beyond satisfying the regulatory requirements for the contract to qualify as a “firm energy forward”) that the seller has access to capacity at or near the delivery point at the time the contract is designated as normal. In addition to the broad regulatory requirement, the buyer would have to consider evidence of the seller’s existing capacity. This requirement could be met if:
-
The seller is known to have generating capacity at or near the delivery point.
-
The sale occurs at a location where the seller has access to a power pool (e.g., New England Power Pool [NEPOOL] and Pennsylvania, New Jersey, and Maryland [PJM]6) that makes generating capacity available to all participants, in which case the buyer can assume such capacity since the power pool would, if necessary, provide it to the seller.
-
Other evidence is obtained that demonstrates that the seller has the available capacity, either through direct ownership of the generating plant or by contract.
For example, if the seller is a power broker that does not have access to a pool, the buyer would have to obtain evidence supporting a conclusion that the seller has access to capacity at or near the delivery point (e.g., a long-term power purchase contract or tolling agreement) to back the contract. Similarly, such evidence would have to be obtained if the seller or a sister company is a known owner of generation but the delivery point in the contract is a location that cannot be served from their owned capacity. -
-
The following criteria are applicable to the seller, as indicated in ASC
815-10-15-45 through 15-51:
-
“The terms of the contract require physical delivery of electricity. That is, the contract does not permit net settlement, as described in paragraphs 815-10-15-100 through 15-109.”
-
“The electricity that would be deliverable under the contract involves quantities that are expected to be . . . sold by the reporting entity in the normal course of business.”
-
“The power purchase or sales agreement is a capacity contract. Differentiating between a capacity contract and a traditional [forward] contract (that is, a financial [forward] on electricity) is a matter of judgment that depends on the facts and circumstances.” For a forward contract to qualify as a capacity contract, both of the following criteria must be met:
-
The purchaser is buying the amount that meet its obligation.The seller could meet this requirement on the basis of its knowledge (including publicly available information) of the buyer’s existing load commitments (i.e., the seller could presume the buyer is purchasing under the contract to meet its load requirements if the buyer is known to have such a requirement at or near the delivery point under the contract). Load requirements would include retail and wholesale requirements and certain contractual requirements. The seller would not have to verify whether the specific quantity being purchased, when added to the buyer’s existing generating capacity and other purchases, would exceed the buyer’s projected power needs. There is a presumption that a sale to a non-load-serving entity (including a power broker or a load-serving utility with no load at or near the delivery point) would not qualify under this criterion. However, that presumption could be overcome if evidence is obtained that demonstrates that the ultimate use of the power will be to fulfill a load-serving requirement (e.g., of a customer of the non-load-serving purchaser). Such evidence can be assumed to exist if the purchaser is a sister company of a load-serving entity that has a load requirement at or near the delivery point.
-
The seller has the capacity to back the contract.To determine whether it meets this requirement, the seller must consider its own existing generating assets plus firm capacity purchase contracts and deduct existing native load requirements and any other existing power sales contracts. In other words, the seller cannot double count the same capacity (i.e., it cannot count existing capacity as both meeting its native load capacity requirements and at the same time backing a sales contract it wishes to qualify as normal). On the other hand, the seller may consider available power resources because the seller has access to a power pool (e.g., NEPOOL and PJM) that makes generating capacity available to all participants. In addition, the seller would have to meet this requirement on the date of the normal designation (i.e., a sales contract would not qualify if the seller intends to obtain the quantity through a future purchase unless (1) the future purchase will be from a power pool that makes generating capacity available to all participants or (2) access to the power pool provides a back-up source to fulfill the delivery obligation).
-
Companies that are members of a consolidated group should apply the above
criteria on the basis of facts existing at the consolidated level. Thus,
for example, if a power-broker subsidiary buys power to sell to a
load-serving sister company, the broker subsidiary’s purchase
transaction would both (1) meet purchaser-criterion 3 (the purchaser has
an obligation to maintain sufficient capacity) and (2) qualify as a
capacity contract (provided that the other criteria are met) at both the
subsidiary and consolidated levels. Similarly, in applying the criteria,
companies may assume certain facts about intercompany relationships with
respect to a contract counterparty’s consolidated group if the
circumstances support such an assumption. For example, a sale to the
power-broker subsidiary of a consolidated group that includes a
load-serving entity would meet seller-criterion 3(a) (i.e., the contract
would qualify as a capacity contract) only if the purchase is at a
location where the load-serving sister company is known to have a load
requirement. On the other hand, without further evidence of the intended
use of the power, seller-criterion 3(a) would not be met in a sale to a
power-broker subsidiary of a consolidated group that includes a
load-serving entity if the delivery point is not at or near the load
requirement of the sister company.
The assessment of whether a contract qualifies for the NPNS scope
exception in ASC 815-10-15-45 through 15-51 must be performed only at
the time the reporting entity elects to apply that exception and
documents compliance with the requirements of ASC 815-10-15-45 through
15-51 (see ASC 815-10-15-37(b)). Therefore, entities should apply these
criteria at that time (which is typically the inception of the
contract).
2.3.2.7 Contract Subsequently Fails to Qualify for the NPNS Scope Exception
As discussed throughout this section, an entity evaluates whether a contract
qualifies for the NPNS scope exception at the inception of the contract. It
is not permitted to “un-elect” this exception on a future date and choose to
instead account for the contract as a derivative instrument (see ASC
815-10-15-39).
However, ASC 815 also acknowledges that a contract may lose its NPNS status.
More specifically, ASC 815-10-15-41 notes that a forward contract containing
a net settlement alternative is not eligible for the NPNS scope exception
“unless it is probable at inception and throughout the term of the
individual contract that the contract will not settle net and will
result in physical delivery” (emphasis added). The paragraph also states
that “[n]et settlement . . . of contracts in a group of contracts similarly
designated as normal purchases and normal sales would call into question
the classification of all such contracts as normal purchases or normal
sales” (emphasis added). Such guidance implies that subsequent
events or management actions can trigger a reassessment of the
appropriateness of continued NPNS designation (i.e., a change in facts or
circumstances may indicate that it is no longer probable the contract will
not settle net). It is clear, however, that an entity’s management cannot
arbitrarily opt to account for a previously designated NPNS contract as a
derivative.
The following are some circumstances that might lead an entity to reassess
whether it still is appropriate to apply the NPNS scope exception to a given contract:
-
The entity is no longer able to assert that it is probable throughout the remaining term of a contract previously designated as NPNS that the contract will not settle net and will result in physical delivery.
-
Changes occur in an entity’s operations, so that quantity purchased or sold under the contract is no longer reasonable in relation to the entity’s projected business needs.
-
The commodity to be purchased under the contract will be resold to third parties instead of used in production.
-
The commodity to be purchased under the contract will be redirected to another entity.
-
The facility to which the commodity will be delivered will no longer be able to use the commodity (or the quantity of the commodity denoted in the contract) in its normal operations, and it is not practical for the quantity of the commodity to be used elsewhere in the entity’s normal operations. This could occur, for example, if there is an anticipated inoperability of the facility for an extended period because of damage sustained in a catastrophe (e.g., fire) or natural disaster (e.g., tornado or hurricane).
-
A significant deterioration in the credit standing of the counterparty to the NPNS contract calls into question the counterparty’s ability to perform under the contract (i.e., delivery is no longer probable).
-
The NPNS contract is amended, and the modified terms are inconsistent with an assertion that it is probable that the NPNS contract will not net settle and the entity will take physical delivery of the commodity.
-
The entity opts to net settle a similar contract that was previously designated as NPNS, instead of taking physical delivery of a commodity.
When a previously designated NPNS contract no longer meets the NPNS criteria,
an entity must also review similar NPNS contracts to ensure that their
continued NPNS designation is appropriate.
If an entity determines that an NPNS contract no longer qualifies for the
scope exception, it should recognize and record the derivative at an amount
equal to the fair value of the contract on the date the NPNS designation no
longer applies, with an offsetting entry to current-period earnings. The
derivative contract may be designated as a hedging instrument in a qualified
hedging relationship if it meets the hedging criteria in ASC 815.
2.3.3 Certain Insurance Contracts
ASC 815-10
15-52 A
contract is not subject to the requirements of this
Subtopic if it entitles the holder to be compensated
only if, as a result of an identifiable insurable event
(other than a change in price), the holder incurs a
liability or there is an adverse change in the value of
a specific asset or liability for which the holder is at
risk. Only those contracts for which payment of a claim
is triggered only by a bona fide insurable exposure
(that is, contracts comprising either solely insurance
or both an insurance component and a derivative
instrument) may qualify for this scope exception. To
qualify, the contract must provide for a legitimate
transfer of risk, not simply constitute a deposit or
form of self-insurance.
15-53 The
following types of contracts written by insurance
entities or held by the insureds are not subject to the
requirements of this Subtopic for the reasons given:
-
Traditional life insurance contracts. The payment of death benefits is the result of an identifiable insurable event (death of the insured) instead of changes in a variable.
-
Traditional property and casualty contracts. The payment of benefits is the result of an identifiable insurable event (for example, theft or fire) instead of changes in a variable.
15-54 In
addition, some contracts with insurance or other
entities combine derivative instruments with other
insurance products or nonderivative contracts, for
example, indexed annuity contracts, variable life
insurance contracts, and property and casualty contracts
that combine traditional coverages with foreign currency
options. Contracts that consist of both derivative
portions and nonderivative portions are addressed in
paragraph 815-15-25-1. However, insurance entities enter
into other types of contracts that may be subject to the
provisions of this Subtopic.
55-44 If the
contract contains a payment provision that requires the
issuer to pay to the holder a specified dollar amount
based on a financial variable, the contract is subject
to the requirements of this Subtopic.
If a contract entitles the holder to be compensated only when (1) there is an
identifiable insurable event (other than a price change), (2) the holder incurs
a liability, or (3) there is a change in the value of a specific asset or
liability that the contract holder is exposed to, such contract does not meet
the requirements of ASC 815. A traditional life insurance or property and
casualty contract typically qualifies for this scope exception because the
payment of benefits is the result of an identifiable insurable event (e.g.,
death of the insured, theft, or fire) rather than changes in a variable.
The section below discusses contracts that provide for payment as a result of
both an identifiable insurance event and some other financial variable.
2.3.3.1 Dual-Trigger Property and Casualty Insurance Contracts
ASC 815-10
15-55 A
property and casualty contract that provides for the
payment of benefits or claims as a result of both an
identifiable insurable event and changes in a
variable would in its entirety not be subject to the
requirements of this Subtopic (and thus not contain
an embedded derivative that is required to be
separately accounted for as a derivative instrument)
provided all of the following conditions are met:
-
Benefits or claims are paid only if an identifiable insurable event occurs (for example, theft or fire).
-
The amount of the payment is limited to the amount of the policyholder’s incurred insured loss.
-
The contract does not involve essentially assured amounts of cash flows (regardless of the timing of those cash flows) based on insurable events highly probable of occurrence because the insured would nearly always receive the benefits (or suffer the detriment) of changes in the variable.
Certain Insurance Contracts — Dual-Trigger
Property and Casualty Insurance Contracts
55-37 A
common characteristic of dual-trigger policies is
that the payment of a claim is triggered by the
occurrence of two events (that is, the occurrence of
both an insurable event and changes in a separate
pre-identified variable). Because the likelihood of
both events occurring is less than the likelihood of
only one of the events occurring, the dual-trigger
policy premiums are lower than traditional policies
that insure only one of the risks. The policyholder
is often purchasing the policy to provide for
coverage against a catastrophe because if both
events occur, the combined impact may be disastrous
to its business.
ASC 815-15
55-12
Paragraphs 815-10-55-37 through 55-39 provide
guidance on dual-trigger insurance contracts and
whether such a contract, in its entirety, is a
derivative instrument subject to the requirements of
Subtopic 815-10. If a contract issued by an
insurance entity involves essentially assured
amounts of cash flows based on insurable events that
are highly probable of occurrence (as discussed in
paragraph 815-10-15-55(c)), an embedded derivative
related to changes in the separate pre-identified
variable for that portion of the contract would be
required to be separately accounted for as a
derivative instrument.
Since a contract that requires the issuer to pay to the holder a specified
dollar amount based on a financial variable would typically be subject to
the requirements of ASC 815, it may seem counterintuitive that ASC 815 would
typically not apply to a dual-trigger policy that pays benefits and
claims in response to both (1) an identifiable insurable event and
(2) changes in a variable. However, such a contract would be outside the
scope of ASC 815 if all of the following conditions are met:
-
The benefits or claims are paid only when the insurable event occurs.
-
The payment amount is limited to the loss incurred.
-
The contract does not involve essentially assured cash flows based on highly probable insurable events.
Normally, a dual-trigger policy results in the payment of a claim when two
events happen at the same time (i.e., when both an insurable event occurs
and a previously identified variable changes). Dual-trigger policies are
less expensive than traditional policies that cover only one risk since the
probability of both events occurring is lower than the chance that only one
will occur.
The FASB implementation guidance below illustrates the application of the
scope exception described above.
ASC 815-10
55-38
Paragraph 815-10-55-40 addresses seven contracts
that illustrate the characteristics of dual-trigger
policies offered to different types of policyholders
that have different risk management needs. All seven
contracts qualify for either the exception in
paragraph 815-10-15-53(b) for traditional property
and casualty contracts or the exception in paragraph
815-10-15-59(b) for non-exchange-traded contracts
involving nonfinancial assets. Therefore, the
dual-trigger variable in those contracts is not
separated and accounted for separately as a
derivative instrument.
55-39 In
contrast, paragraph 815-15-55-12 states that, if a
contract issued by an insurance entity involves
essentially assured amounts of cash flows based on
insurable events that are highly probable of
occurrence (as discussed in paragraph
815-10-15-55(c)), an embedded derivative related to
changes in the separate pre-identified variable for
that portion of the contract would be required to be
separately accounted for as a derivative
instrument.
55-40
Following are descriptions of seven contracts:
-
Contract A — electric utility. A dual-trigger policy pays for a level of actual losses caused by the following two events occurring simultaneously:
-
A power outage resulting from equipment failure or storm-related damage causes more than 500 megawatts of lost power.
-
The spot market price for power exceeds $65 per megawatt hour during the storm or equipment failure period.
The contract pays the difference between the strike price and the actual market price for the lost power (that is, the cost of replacement power). -
-
Contract B — trucking delivery entity. A dual-trigger policy pays extra expenses associated with rerouting trucks over a certain time period if snowfall exceeds a specified level during that time period. The snowfall causes delays and creates the need to reroute trucks to meet delivery demands.
-
Contract C — hospital. A dual-trigger policy pays actual medical malpractice claims above a specified level only if the value of the hospital’s equity portfolio falls below a specified level during the same period.
-
Contract D — iron ore mining entity. A dual-trigger policy pays a specified level of workers’ compensation claims (not to exceed actual claims) if the claims exceed a specified level at the same time iron ore prices decrease below a specified level.
-
Contract E — golf resort in Florida. A dual-trigger policy pays property damage from hurricanes incurred by a specific golf resort in Florida; however, the losses are covered only if other golf courses in the region incur hurricane-related losses and the claims cannot exceed the average property damages incurred by the other golf resorts in the county.
-
Contract F — cherry orchard in Michigan. A dual-trigger policy pays crop losses incurred due to bad weather during growing season, and the claims are at risk of being reduced based on changes in the inflation rate in Brazil. The cherry producer has no operations in Brazil or any transactions in Brazilian currency. However, a Brazilian cherry producer exports cherries to the United States and is a competitor of the Michigan cherry producer.
-
Contract G — property-casualty reinsurance contract. Reinsurance contracts, which indemnify the holder of the contract (the reinsured) against loss or liability relating to insurance risk, are accounted for under the provisions of Topic 944. Reinsurance contract provisions often adjust the amount at risk or the price of the amount at risk for a number of events or circumstances, such as loss experience or premium volume, while continuing to provide indemnification related to insurance risk. One type of reinsurance contract, an excess contract, provides the reinsured with indemnification against a finite amount of insured losses in excess of a defined level of insured losses retained by the reinsured. Example 11 (see paragraph 815-10-55-132) illustrates a reinsurance contract with a provision that adjusts the retention amount downward based on the performance of a specified equity index.
Example 11: Certain Insurance Contracts —
Dual-Trigger Property-Casualty Reinsurance
Contract
55-132 This
Example illustrates a reinsurance contract with a
provision that adjusts the retention amount downward
based on the performance of a specified equity index
as discussed in paragraph 815-10-55-40(g). Reinsurer
enters into a reinsurance contract with Reinsured to
indemnify Reinsured for certain insured losses in
excess of a defined retention. The intent of the
coverage is to protect Reinsured from significant or
catastrophic property-casualty losses. The coverage
would include a retention amount that would be
adjusted downward according to a scale tied to the
Dow Jones Industrial Average. If a catastrophic loss
occurs, Reinsured would likely have to liquidate
some of its investment holdings (bonds or equities)
to pay its losses, which exposes Reinsured to
significant investment risk in a down market. The
adjustment feature provides protection against
investment risk by allowing Reinsured to recover
more losses in a declining investment market.
Reinsured has no ability to receive appreciation in
the Dow Jones Industrial Average.
-
Parties: Reinsurer and Reinsured
-
Coverage: Property losses
-
Period: January 1, X1, through December 31, X1
-
Retention: $20 million per occurrence, adjusted downward in the same percentage as period-to-date (from January 1, X1, to measurement date) decreases in the Dow Jones Industrial Average, not to exceed 50%
-
Limit: $15 million per occurrence, $15 million per annum
-
Premium: $1.4 million per annum.
55-133 Both
of the following scenarios assume that the Dow Jones
Industrial Average on January 1, X1, was 10,000.
55-133A As
discussed in paragraph 815-10-55-38, the contract
qualifies for the exception in paragraph
815-10-15-53(b) for traditional property and
casualty contracts and, so, the dual-trigger
variable in the contract is not separated and
accounted for separately as a derivative
instrument.
Example 12: Certain Insurance Contracts —
Essentially Assured Amounts
55-134 This
Example illustrates the guidance in paragraph
815-10-15-55(c) for a contract involving essentially
assured amounts. Insured Entity has received at
least $2 million in claim payments from its
insurance entity (or at least $2 million in claim
payments were made by the insurance entity on the
insured entity’s behalf) for each of the previous 5
years related to specific types of insured events
that occur each year. That minimum level of coverage
would not qualify for the insurance contract scope
exclusion.
2.3.3.2 Contracts With Highly Probable Insured Events
ASC 815-10
15-56 If
there is an actuarially determined minimum amount of
expected claim payments that are the result of
insurable events that are highly probable of
occurring under the contract, that portion of the
contract does not qualify for the insurance scope
exception if both of the following conditions are
met:
-
Those minimum payment cash flows are indexed to or altered by changes in a variable.
-
Those minimum payment amounts are expected to be paid each policy year (or on another predictable basis).
15-57 If an
insurance contract has an actuarially determined
minimum amount of expected claim payments that are
highly probable of occurring, then effectively the
amount of those claims is the contract’s minimum
notional amount in determining the embedded
derivative under Section 815-15-25.
ASC 815-10-15-56 notes that when “an actuarially determined minimum amount of
expected claim payments [results from] insurable events that are highly
probable of occurring under the contract, that portion of the contract does
not qualify for the insurance scope exception if both of [the conditions in
ASC 815-10-15-56 shown above] are met.” The FASB implementation guidance
below illustrates the application of this guidance.
ASC 815-10
15-55 A
property and casualty contract that provides for the
payment of benefits or claims as a result of both an
identifiable insurable event and changes in a
variable would in its entirety not be subject to the
requirements of this Subtopic (and thus not contain
an embedded derivative that is required to be
separately accounted for as a derivative instrument)
provided all of the following conditions are met: .
. .
c. The contract does not involve essentially
assured amounts of cash flows (regardless of the
timing of those cash flows) based on insurable
events highly probable of occurrence because the
insured would nearly always receive the benefits
(or suffer the detriment) of changes in the
variable.
Example 12: Certain Insurance Contracts —
Essentially Assured Amounts
55-134 This
Example illustrates the guidance in paragraph
815-10-15-55(c) for a contract involving essentially
assured amounts. Insured Entity has received at
least $2 million in claim payments from its
insurance entity (or at least $2 million in claim
payments were made by the insurance entity on the
insured entity’s behalf) for each of the previous 5
years related to specific types of insured events
that occur each year. That minimum level of coverage
would not qualify for the insurance contract scope
exclusion.
2.3.4 Certain Financial Guarantee Contracts
ASC 815-10
15-58
Financial guarantee contracts are not subject to this
Subtopic only if they meet all of the following
conditions:
-
They provide for payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a nonderivative contract, either:
-
At prespecified payment dates
-
At accelerated payment dates as a result of either the occurrence of an event of default (as defined in the financial obligation covered by the guarantee contract) or notice of acceleration being made to the debtor by the creditor.
-
-
Payment under the financial guarantee contract is made only if the debtor’s obligation to make payments as a result of conditions as described in (a) is past due.
-
The guaranteed party is, as a precondition in the contract (or in the back-to-back arrangement, if applicable) for receiving payment of any claim under the guarantee, exposed to the risk of nonpayment both at inception of the financial guarantee contract and throughout its term either through direct legal ownership of the guaranteed obligation or through a back-to-back arrangement with another party that is required by the back-to-back arrangement to maintain direct ownership of the guaranteed obligation.
In contrast, financial guarantee contracts are subject to
this Subtopic if they do not meet all three criteria,
for example, if they provide for payments to be made in
response to changes in another underlying such as a
decrease in a specified debtor’s creditworthiness.
Credit Derivatives
55-45 Many
different types of contracts are indexed to the
creditworthiness of a specified entity or group of
entities, but not all of them are derivative
instruments. Credit-indexed contracts that have certain
characteristics described in paragraph 815-10-15-58 are
guarantees and are not subject to the requirements of
this Subtopic. Credit-indexed contracts (often referred
to as credit derivatives) that do not have the
characteristics necessary to qualify for the exception
in that paragraph are subject to the requirements of
this Subtopic. One example of the latter is a
credit-indexed contract that requires a payment due to
changes in the creditworthiness of a specified entity
even if neither party incurs a loss due to the change
(other than a loss caused by the payment under the
credit-indexed contract).
It is somewhat common for one entity to provide a financial guarantee to another
entity. For example, a subsidiary may be the legal issuer of a debt instrument
but the lender requires the parent to provide a financial guarantee on the
borrowed amount. A typical financial guarantee would be likely to qualify for
this scope exception.
However, if a financial guarantee does not meet one (or more) criterion in ASC
815-10-15-58 and would otherwise meet the definition of a derivative instrument
in ASC 815, the guarantee contract would be accounted for as a derivative
instrument. It is important to note that in the application of the guidance in
ASC 815-10-15-58, a financial guarantee with a non-payment-based trigger (e.g.,
a credit downgrade) would not qualify for the scope exception because the
guarantor payments would not be made “solely to reimburse the guaranteed party
for failure of the debtor to satisfy its required payment obligations”
(emphasis added).
Paragraphs A21 and A22 of the Background Information and Basis for Conclusions of FASB Statement 149 (which, although not part of ASC 815, are relevant to this
topic) provide further background on this requirement, stating, in part:
In considering this issue, the Board discussed two possible alternatives:
(a) amend paragraph 10(d) to permit financial guarantee contracts that
provide protection to a guaranteed party in any event of default to
qualify for the scope exception or (b) clarify paragraph 10(d) to
emphasize the need for the guaranteed party to demand payment
prior to collecting any payment from the guarantor in order for a
guarantee contract to be eligible for the scope exception. Both
alternatives contemplate that, as part of the financial guarantee
arrangement, the guarantor receives either the rights to any payments
subsequently advanced to the guaranteed party or delivery of the
defaulted receivable upon an event of default.
The Board selected the second alternative, because it is more
consistent with the Board’s original intent in Statement 133. The Board concluded that the intent of the scope exception for guarantee contracts in paragraph 10(d) of Statement 133 was to more closely align
that exception with the scope exception for traditional insurance
contracts addressed in paragraph 10(c). The Board reasoned that
guarantees eligible for the scope exception are similar to insurance
contracts in that they entitle the holder to compensation only if, as a
result of an insurable event (other than a change in price), the holder
incurs a liability or there is an adverse change in the value of a
specific asset or liability for which the holder is at risk.
Accordingly, the Board determined that, in order for a financial
guarantee contract to qualify for the scope exception in paragraph
10(d), the guaranteed party must demand payment from the debtor and
that once it is determined that the required obligation will not be
satisfied by the debtor, the guaranteed party must relinquish to the
guarantor its rights to receive payment from the debtor in order to
receive payment from the guarantor. [Emphasis added]
Example 2-8
Non-Payment-Based Financial Guarantee
Entity S purchases a guarantee contract from Entity P on
a portfolio of S’s debt securities. Under the terms of
the guarantee, S can deliver a debt security to P in
return for the par amount of the debt security if the
underlying debtor enters into bankruptcy (broadly
defined as including liquidations and creditor
protection/standstill agreements). Because the trigger
on the financial guarantee contract is not payment-based
(i.e., payment under the guarantee is not based on the
debtor’s failure to make a past-due contractual
payment), the financial guarantee contract would not
qualify for the financial guarantee scope exception.
Example 2-9
Payment-Based Financial Guarantee
Entity E purchases a guarantee contract from Entity M on
a portfolio of E’s originated loans. Under the terms of
the guarantee, M pays E if a debtor on an underlying
loan contract fails to make a contractually specified
payment (e.g., principal or interest shortfall).
Because the trigger on the financial guarantee contract
is payment-based (i.e., payment under the guarantee is
based on the debtor’s failure to make a past-due
contractual payment), the financial guarantee contract
would qualify for the financial guarantee scope
exception.
The implementation example below illustrates the application of the
aforementioned guidance to dual-trigger financial guarantee contracts.
ASC 815-10
Dual-Trigger Financial Guarantee
Contracts
55-32 Entity ABC extends credit
to consumers through credit cards and personal loans of
various sorts. Entity ABC is exposed to credit losses
from its managed asset portfolio, including owned and
securitized receivables. Entity ABC would like to
purchase an insurance policy to protect itself against
high levels of consumer default.
55-33 The proposed insurance
policy will entitle Entity ABC to collect claims to the
extent that its credit losses exceed a specified minimum
level but limited to the amount by which the credit
losses on a customized pool or index of consumer loans
exceed that same specified minimum level. Thus, Entity
ABC will collect claims based on the lesser of the
following:
-
Entity ABC’s actual credit losses
-
The credit losses on a customized pool or index of consumer loans.
55-34 Although the insurer’s
payment to Entity ABC may be affected by credit losses
on a customized pool, the payment nevertheless
represents compensation for actual credit losses Entity
ABC incurred. Entity ABC purchases this insurance to
obtain a lower premium because claims are limited by
external charge-off rates and the insurer is not exposed
to Entity ABC’s underwriting performance.
55-35 This type of control may
also exist in property and casualty reinsurance
policies. For example, an insurance entity may purchase
reinsurance that covers actual hurricane losses in
excess of a specified level in their block of business,
but the coverage does not apply to losses in excess of a
geographically diversified index of hurricane
losses.
55-36 Financial guarantee
insurance contracts are not subject to this Subtopic
only if all of the conditions in paragraph 815-10-15-58
are met. The description of the financial guarantee
insurance contract in paragraph 815-10-55-32 is
insufficient for determining whether those conditions
are met. The following provisions of that contract
represent a type of deductible and do not affect the
application of the conditions in paragraph
815-10-15-58:
-
The provision that limits any claims to the extent that Entity ABC’s actual credit losses exceed a specified minimum level
-
The provision that limits any payments for those claims to the amount by which the credit losses on a customized pool or index of consumer loans exceed that same specified minimum level.
2.3.5 Certain Contracts That Are Not Traded on an Exchange
ASC 815-10
15-59 Contracts that are not
exchange-traded are not subject to the requirements of
this Subtopic if the underlying on which the settlement
is based is any one of the following:
-
A climatic or geological variable or other physical variable. Climatic, geological, and other physical variables include things like the number of inches of rainfall or snow in a particular area and the severity of an earthquake as measured by the Richter scale. (See Example 13 [paragraph 815-10-55-135].)
-
The price or value of a nonfinancial asset of one of the parties to the contract provided that the asset is not readily convertible to cash. This scope exception applies only if both of the following are true:
-
The nonfinancial assets are unique.
-
The nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset. (If the contract is a call option, the scope exception applies only if that nonfinancial asset is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset above the option’s strike price.)
-
-
The fair value of a nonfinancial liability of one of the parties to the contract provided that the liability does not require delivery of an asset that is readily convertible to cash.
-
Specified volumes of sales or service revenues of one of the parties to the contract. (This scope exception applies to contracts with settlements based on the volume of items sold or services rendered, for example, royalty agreements. This scope exception does not apply to contracts based on changes in sales or revenues due to changes in market prices.)
15-60 If a contract has more
than one underlying and some, but not all, of them
qualify for one of the scope exceptions in the preceding
paragraph, the application of this Subtopic to that
contract depends on its predominant characteristics.
That is, the contract is subject to the requirements of
this Subtopic if all of its underlyings, considered in
combination, behave in a manner that is highly
correlated with the behavior of any of the component
variables that do not qualify for a scope exception.
15-61 A contract based on any
variable that is not specifically excluded by paragraph
815-10-15-59 is subject to the requirements of this
Subtopic if it has the other two characteristics
(initial net investment and net settlement) identified
in this Subsection.
ASC 815 also provides a series of potential scope exceptions for certain
contracts that are not traded on an exchange. These exceptions are discussed in
more detail below.
2.3.5.1 Climatic, Geological, or Other Physical Variables
ASC 815-10-15-59(a) includes a scope exception for non-exchange-traded
contracts whose settlement is based on a climatic, geological, or other
physical variable. Examples of payment features that may qualify for this
exception include those based on measures of rainfall, snow, wind velocity,
floodwater, or the severity of an earthquake or the occurrence of a
hurricane. However, this scope exception is not available if the payment
feature is also indexed to a financial variable, such as the dollar amount
of hurricane losses (see ASC 815-10-55-137). Nevertheless, such a feature
may be exempt from ASC 815 under the scope exception in ASC 815-10-15-52
through 15-57 for insurance contracts if “it entitles the holder to be
compensated only if, as a result of an identifiable insurable event (other
than a change in price), the holder incurs a liability or there is an
adverse change in the value of a specific asset or liability for which the
holder is at risk” (e.g., a decline in revenue as a result of a hurricane
event). ASC 815-10-55-135 through 55-141 provide three examples of contracts
that illustrate how to distinguish between physical and financial variables,
as shown below.
ASC 815-10
Example 13: Certain Contracts That Are Not
Traded on an Exchange — Distinguishing Between
Physical and Financial Variables
55-135 The
following Cases illustrate the difference between
physical and financial variables for purposes of
applying the scope exception in paragraph
815-10-15-59(a):
-
Contract containing both a physical variable and a financial variable (Case A)
-
Contract containing only a physical variable (Case B)
-
c. Contract containing only a financial variable (Case C).
Case A: Contract Containing Both a Physical Variable
and a Financial Variable
55-136 A
contract’s payment provision specifies that the
issuer will pay to the holder $10,000,000 if
aggregate property damage from all hurricanes in the
state of Florida exceeds $50,000,000 during the year
2001.
55-137 In
this Case, the payment under the contract occurs if
aggregate property damage from all hurricanes in the
state of Florida exceeds $50,000,000 during the year
2001. The contract contains 2 underlyings — a
physical variable (that is, the occurrence of at
least 1 hurricane) and a financial variable (that
is, aggregate property damage exceeding a specified
or determinable dollar limit of $50,000,000).
Because of the presence of the financial variable as
an underlying, the derivative instrument does not
qualify for the scope exclusion in paragraph
815-10-15-59(a).
Case B: Contract Containing Only a Physical
Variable
55-138 A
contract specifies that the issuer pays the holder
$10,000,000 in the event that a hurricane occurs in
Florida in 2001.
55-139 If a
contract contains a payment provision that requires
the issuer to pay to the holder a specified dollar
amount that is linked solely to a climatic or other
physical variable (for example, wind velocity or
flood-water level), paragraph 815-10-15-59(a)
provides that the contract is not subject to the
requirements of this Subtopic.
55-140 In
this Case, the payment provision is triggered if a
hurricane occurs in Florida in 2001. The underlying
is a physical variable (that is, occurrence of a
hurricane). Therefore, the contract qualifies for
the scope exclusion in paragraph
815-10-15-59(a).
Case C: Contract Containing Only a Financial
Variable
55-141 A
contract would be a traditional insurance contract
that is excluded from the scope of this Subtopic
under the exception discussed beginning in paragraph
815-10-15-52 if the contract requires a payment only
if the holder incurs a decline in revenue or an
increase in expense as a result of an event (for
example, a hurricane) and the amount of the payoff
is solely compensation for the amount of the
holder’s loss.
2.3.5.2 Certain Nonfinancial Items of One of the Parties to the Contract
ASC 815-10
15-59
Contracts that are not exchange-traded are not
subject to the requirements of this Subtopic if the
underlying on which the settlement is based is any
one of the following: . . .
b. The price or value of a nonfinancial asset
of one of the parties to the contract provided
that the asset is not readily convertible to cash.
This scope exception applies only if both of the
following are true:
1. The nonfinancial
assets are unique.
2. The nonfinancial
asset related to the underlying is owned by the
party that would not benefit under the contract
from an increase in the fair value of the
nonfinancial asset. (If the contract is a call
option, the scope exception applies only if that
nonfinancial asset is owned by the party that
would not benefit under the contract from an
increase in the fair value of the nonfinancial
asset above the option’s strike price.) . .
.
Example 14: Certain Contracts That Are Not
Traded on an Exchange — Nonfinancial Asset of One
of the Parties to a Contract
55-142 This
Example addresses the application of the scope
exception in paragraph 815-10-15-59(b). Entity A
enters into a non-exchange-traded forward contract
to buy from Entity B 100 interchangeable (fungible)
units of a nonfinancial asset that are not readily
convertible to cash. The contract permits net
settlement through its default provisions. Entity A
already owns more than 100 units of that
nonfinancial asset, but Entity B does not own any
units of that nonfinancial asset.
55-143 The
scope exception in paragraph 815-10-15-59(b) does
not apply to the accounting for the contract for
both of the following reasons:
-
The contract’s settlement is based on an underlying associated with a nonfinancial asset that is not unique (because it is based on the price or value of an interchangeable, nonfinancial unit).
-
The entity that owns the nonfinancial asset related to the underlying (that is, Entity A) is the buyer of the units and thus would benefit from the forward contract if the price or value increases.
Consequently, neither Entity A nor Entity B qualifies
for the scope exception in paragraph
815-10-15-59(b).
ASC 815-10-15-59 contains a scope exception for certain non-exchange-traded
contracts whose settlement is based on the “price or value of a nonfinancial
asset of one of the parties to the contract” (i.e., property owned by the
debtor) or the “fair value of a nonfinancial liability of one of the parties
to the contract.” This scope exception is not available for underlyings
associated with nonfinancial assets that are (1) RCC or (2) not unique
(e.g., fungible, interchangeable items).
Original works of art or real estate would be considered unique nonfinancial
assets (i.e., they do not have interchangeable units). Assets that are newly
produced on an assembly line (have not been used) and available from
multiple sellers are not unique since a new asset is interchangeable with
another new asset from the same production. However, once the manufactured
asset has been used, the asset would be considered unique (e.g., a used car
is considered unique).
Further, the scope exception for certain nonfinancial assets of one of the
parties is only available if the nonfinancial asset is owned by the party
that would not benefit under the contract from an increase in the price or
value of the nonfinancial asset. In other words, the scope exception is not
available if the contract benefits the owner of the nonfinancial asset when
the fair value of the nonfinancial asset increases. For example, the scope
exception is not available if payments required under a debt obligation
decrease when the fair value of a nonfinancial asset owned by the debtor
increases (i.e., the owner of the nonfinancial asset — the debtor — benefits
under the contract from an increase in the fair value of the asset because
such increase results in a decrease in the payments to be made on the debt
obligation).
ASC 815-15
55-8 Under an
example participating mortgage, the investor
receives a below-market interest rate and is
entitled to participate in the appreciation in the
fair value of the project that is financed by the
mortgage upon sale of the project, at a deemed sale
date, or at the maturity or refinancing of the loan.
The mortgagor must continue to own the project over
the term of the mortgage.
55-9 This
instrument has a provision that entitles the
investor to participate in the appreciation of the
referenced real estate (the project). However, a
separate contract with the same terms would be
excluded by the exception in paragraph
815-10-15-59(b) because settlement is based on the
value of a nonfinancial asset of one of the parties
that is not readily convertible to cash. (This
Subtopic does not modify the guidance in Subtopic
470-30.)
55-10
Paragraph 310-10-05-9 explains that loans granted to
acquire operating properties sometimes grant the
lender a right to participate in expected residual
profit from the sale or refinancing of the property.
An equity kicker (or expected residual profit) would
typically not be separated from the host contract
and accounted for as an embedded derivative because
paragraph 815-15-25-1(c) exempts a hybrid contract
from bifurcation if a separate instrument with the
same terms as the embedded equity kicker is not a
derivative instrument subject to the requirements of
this Subtopic. Under paragraph 815-10-15-59(b), an
embedded equity kicker would typically not be
subject to the requirements of this Subtopic because
the separate instrument with the same terms is not
exchange traded and is indexed to nonfinancial
assets that are not readily convertible to cash.
Similarly, if an equity kicker is based on a share
in net earnings or operating cash flows, it would
also typically qualify for the scope exception in
paragraph 815-10-15-59(d). If the embedded
derivative does not need to be accounted for
separately under this Subtopic, the Acquisition,
Development, and Construction Arrangements
Subsections of Subtopic 310-10 shall be applied.
An example of a feature for which the scope exception in ASC 815-10-15-59
would typically be available is the participation feature in a participating
mortgage, which would instead be accounted for under ASC 470-30.
Example 2-10
Milestone and Regulatory Approval Payments
RevoMed Company enters into a contract to acquire
intellectual property (IP) (e.g., a license) from
ResearchOrg, which represents a development platform
designed to provide drug developers with a
revolutionary approach to delivering a particular
medicine (the “product”). In connection with the
acquisition of the IP, RevoMed is required to make
milestone payments to ResearchOrg related to
clinical development milestones and subsequent
product approvals that leverage the acquired
platform in the development of the product.
The underlying on which the settlement is based is
related to a nonfinancial asset — the acquired IP.
The milestone payments become due after clinical
development milestones and the successful product
approvals that leverage the acquired IP. Although
there may or may not be an asset recorded on the
balance sheet for each milestone payment (i.e., some
of the payments may not qualify for capitalization),
the achievement of the milestones is highly
correlated to the IP’s fair value (i.e., once the
milestones are achieved, the fair value
increases).
In this example, the acquired IP is considered a
unique nonfinancial asset because any products that
leverage this technology represent complex,
scientifically engineered therapies supported by a
one-of-a-kind platform that are not readily
interchangeable with similar products in the market
(i.e., the products are not “assembly line
widgets”). Further, the product rights are owned by
RevoMed, and RevoMed would not benefit under the
terms of the contract from an increase in the fair
value of the acquired IP. This is because in the
evaluation of whether the scope exception in ASC
815-10-15-59(b) applies, the contract is the
milestone payment arrangement between RevoMed and
ResearchOrg. Since RevoMed can only make a payment
to the counterparty under this arrangement, it
cannot benefit under the contract. While RevoMed
obviously does benefit from the achievement of
reaching clinical development milestones and the
ultimate regulatory approval of new product
offerings that leverage the acquired IP, the benefit
to RevoMed arises from owning the underlying
nonfinancial asset and not from the contract that
results in milestone payments to ResearchOrg.
Hence, the scope exception described in ASC
815-10-15-59(d) for certain contracts that are not
traded on an exchange may be applied in this fact
pattern.
Note that if the above fact pattern applied to an
R&D funding arrangement, as opposed to the
acquisition of a license (see Section
2.3.5.4), it is most likely that the
entity would not reach the same conclusion regarding
the applicability of the scope exception.
2.3.5.3 Certain Revenue-Based Payments
ASC 815-10
15-59
Contracts that are not exchange-traded are not
subject to the requirements of this Subtopic if the
underlying on which the settlement is based is any
one of the following: . . .
d. Specified volumes of sales or service
revenues of one of the parties to the contract.
(This scope exception applies to contracts with
settlements based on the volume of items sold or
services rendered, for example, royalty
agreements. This scope exception does not apply to
contracts based on changes in sales or revenues
due to changes in market prices.)
15-60 If a
contract has more than one underlying and some, but
not all, of them qualify for one of the scope
exceptions in the preceding paragraph, the
application of this Subtopic to that contract
depends on its predominant characteristics. That is,
the contract is subject to the requirements of this
Subtopic if all of its underlyings, considered in
combination, behave in a manner that is highly
correlated with the behavior of any of the component
variables that do not qualify for a scope
exception.
ASC 815-10-15-59(d) provides a scope exception for derivatives in which the
underlying is based on “[s]pecified volumes of sales or service revenues of
one of the parties to the contract.” This scope exception in many
circumstances may be applied to contracts for which the underlying is a
broad performance measure of one of the parties to the contract (e.g., net
earnings, EBITDA, or operating cash flows). Discussions with the FASB staff
have indicated that the application of this exception is limited by the
wording of ASC 815-10-15-59(d), which states, in part:
This scope exception does not apply to contracts based on changes in
sales or revenues due to changes in market prices.
Accordingly, if the performance measure is based primarily or wholly on the
volume of items sold or services rendered of one of the parties to the
contract, an embedded feature whose underlying is based on that performance
measure potentially could qualify for the ASC 815-10-15-59(d) scope
exception. However, the scope exception is not available if changes in the
performance measure are highly correlated with changes in the market price
of an asset or liability (e.g., changes in the market price of investments
held or goods sold).
Example 2-11
Payments Based on Revenue
B Pharma LLC is a life sciences company formed on
June 26, 20X8. On February 14, 20X9, B completed an
equity financing transaction with Company P. On the
same date, B executed a revenue-sharing agreement
(RSA) with P. The RSA grants P the right to receive
2 percent of the net sales of any of B’s products
(1) over a period of 12 years from the first sale of
that product or (2) until the product’s patent has
expired, whichever is later. All payments required
by the terms of the RSA must be made in immediately
available funds from a bank account domiciled in the
United States (i.e., in U.S. dollars) unless
otherwise agreed by P.
The RSA meets the definition of a derivative because
it has an underlying (B’s net sales) and a payment
provision (cash payments to P), and P’s initial net
investment is smaller than the amount that would be
exchanged to acquire the asset related to the
underlying. Finally, the contract provides for net
settlement in cash.
Although the arrangement meets the components of the
derivative definition, it is not required to be
accounted for as a derivative if it qualifies for a
scope exception. The RSA includes settlements that
are based on the volume of sales of B’s products and
therefore meets the scope exception in ASC
815-10-15-59(d). Therefore, B is not required to
account for the RSA as a derivative instrument under
ASC 815.
Example 2-12
Payments Based on Policy Claims
Company P holds business interruption insurance
policies with various insurers and is seeking
indemnity under those policies for losses and
damages arising from, or directly related to, recent
events (the “policy claims”). The policy claims are
in various stages of litigation.
On February 26, 20X1, P enters into a participation
agreement with Company B (the participant), an
unrelated third party. Under that agreement, P sells
a participation interest in future insurance
recoveries under the policy claims. In exchange for
that interest, P receives cash consideration of $80
million (the participation price) and is entitled to
future amounts, subject to a distribution waterfall
(i.e., a schedule that prescribes the distributions
to P and B) outlined in the participation agreement,
in the event that recoveries (proceeds) are
collected from its insurers.
The participation agreement meets the definition of a
derivative because:
-
The occurrence or nonoccurrence of this specified event (i.e., the receipt of proceeds from the policy claims) represents an underlying in the participation agreement. Upon receiving proceeds from the policy claims, P is required to pay B a determinable amount based on the waterfall outlined in the agreement. This represents a payment provision because there are specified determinable settlements to be made if the underlying (i.e., the receipt of proceeds) behaves in a certain manner.
-
The agreement did not result in B’s acquiring ownership of the policy claims. Rather, P remains the sole owner of the policy claims, and B will receive a portion of the proceeds related to such claims. In addition, the participation price is significantly less than the maximum potential proceeds from those claims, and it is also less than the anticipated proceeds from the policy claims. Therefore, the initial net investment that B makes in the form of participation price is smaller than the amount that would be exchanged to acquire the asset related to the underlying (i.e., reimbursement of losses and damages arising from the insurable events).
-
The participation agreement provides that upon receipt of proceeds from the policy claims, P must make its payments to B in cash.
The underlying in the contract is based on the
receipt of the potential proceeds from the policy
claims, which is a measure of P’s net earnings and
operating cash flows. Furthermore, under the
waterfall, the distributions of potential proceeds
from the policy claims to B are not highly
correlated with changes in the market price of an
asset or liability (e.g., changes in the market
price of investments held or goods sold). Instead,
such payments to B are based upon a specified
percentage of proceeds (i.e., P’s operational
results) received from the policy claims, which is
not determined on the basis of changes in the market
price of an asset or liability. That is, the
potential proceeds from the policy claims are
directly related to P’s business and represent
reimbursement for losses and damages incurred as a
result of the insured events. Therefore, in
accordance with ASC 815-10-15-59(d), the
participation agreement is outside the scope of ASC
815.
Example 2-13
Lease Contracts That Contain
Provisions for Rental Increases That Are Based on
Sales Volume7
Company ABC leases property in Germany from Company
XYZ. The lease provides for annual rent increases
that are based on a percentage of ABC’s retail sales
in Germany during the calendar year. Each increase
is an adjustment to the following year’s rent
payments.
The lease contains an embedded contingent rent
payment that is based on ABC’s retail sales in
Germany. The embedded derivative does not require
separate accounting because ABC’s retail sales would
qualify for the scope exception in ASC
815-10-15-59(d) for non-exchange-traded contracts
with underlyings that are “the sales or service
revenues of one of the parties to the contract.”
Therefore, this embedded derivative on a percentage
of ABC’s German retail revenues would not meet the
definition of a derivative on a freestanding basis
and would not require bifurcation in accordance with
ASC 815-15-25-1(c).
Example 2-14
Debt That Contains Interest Payments Indexed to
EBITDA
Company H has issued debt that includes an additional
interest payment based on an increase in H’s EBITDA
that exceeds a specified threshold. Thus, increases
in EBITDA above the threshold increase the amount of
additional interest payments required. Company H
determined that EBITDA is not an interest-rate index
but an earnings measure that is not clearly and
closely related to the debt host. Company H
evaluates whether the additional interest payment
feature that is based on EBITDA is an embedded
derivative that must be accounted for
separately.
It would be appropriate for H to apply the scope
exception in ASC 815-10-15-59(d) as long as the
changes in EBITDA are not primarily driven by market
price changes. A contingent interest feature based
on EBITDA would not qualify for the ASC
815-10-15-59(d) scope exception if changes in EBITDA
are highly correlated with changes in the market
price of an asset or liability (e.g., changes in the
market price of investments held or goods sold).
2.3.5.4 R&D Funding Arrangements
In a typical R&D funding arrangement (common for life sciences entities),
passive third-party investors often provide funds to offset the cost of
R&D programs in exchange for milestone payments or other forms of
consideration (typically sales-based royalties) that are contingent on the
successful completion of such R&D programs and the related approval for
the compound or compounds being developed. To determine the appropriate
accounting treatment, an entity should first consider whether the
arrangement includes elements that need to be accounted for under the
guidance on derivatives in ASC 815.
Depending on the terms of the transaction, an R&D funding arrangement may
contain an underlying (e.g., the underlying net sales, which are dependent
on regulatory approval) and a payment provision (e.g., sales-based royalty
payments to the investor, which are based on future levels of net sales of
the compound being developed) without an initial net investment (i.e., the
investor may only be required to fund the R&D costs because such costs
are incurred). In addition, R&D funding arrangements often contain the
characteristic of explicit net settlement since they are settled in
cash.
If the R&D funding arrangement meets the definition of a derivative
instrument, an entity should assess whether the arrangement represents a
contract that would meet any of the scope exceptions in ASC 815. For
example, in certain transactions, the fund recipient is only required to
make royalty payments to the investor if the compound is approved and net
sales occur. In these circumstances, the scope exception described in ASC
815-10-15-59(d) for certain contracts that are not traded on an exchange may
apply.
2.3.6 Derivative Instruments That Impede Sale Accounting
ASC 815-10
15-63 A
derivative instrument (whether freestanding or embedded
in another contract) whose existence serves as an
impediment to recognizing a related contract as a sale
by one party or a purchase by the counterparty is not
subject to this Subtopic. An example is the existence of
a call option enabling a transferor to repurchase
transferred assets that is an impediment to sales
accounting under Topic 860. Such a call option on
transferred financial assets that are not readily
obtainable would prevent accounting for that transfer as
a sale. The consequence is that to recognize the call
option would be to count the same thing twice. The
holder of the option already recognizes in its financial
statements the assets that it has the option to
purchase.
15-64 A
derivative instrument held by a transferor that relates
to assets transferred in a transaction accounted for as
a financing under Topic 860, but which does not itself
serve as an impediment to sale accounting, is not
subject to the requirements of this Subtopic if
recognizing both the derivative instrument and either
the transferred asset or the liability arising from the
transfer would result in counting the same thing twice
in the transferor’s balance sheet. However, if
recognizing both the derivative instrument and either
the transferred asset or the liability arising from the
transfer would not result in counting the same thing
twice in the transferor’s balance sheet, the derivative
instrument shall be accounted for in accordance with
this Subtopic. For related implementation guidance, see
paragraph 815-10-55-41.
55-41 The
following guidance illustrates application of the scope
exception (as discussed beginning in paragraph
815-10-15-63) for a derivative instrument that impedes
sales accounting to situations in which the transferor
accounts for the transfer as a financing:
-
If a transferor transfers financial assets but retains a call option on those assets, the net settlement criterion (as discussed beginning in paragraph 815-10-15-119) may be satisfied because the assets transferred are readily obtainable; however, the transfer may fail the isolation criterion in paragraph 860-10-40-5(a) because of significant continued involvement by the transferor. In that example, because the transferor is required to continue to recognize the assets transferred, recognition of the call option on those assets would effectively result in recording the assets twice. Therefore, the derivative instrument is not subject to the scope of this Subtopic.
-
In the situation described in (a), the transferor may have sold to the transferee a put option. Exercise of the put option by the transferee would result in the transferor repurchasing certain assets that it has transferred, but which it still records as assets in its balance sheet. Because the transferor is required to recognize the borrowing, recognition of the put option would result in recording the liability twice. Therefore, the derivative instrument is not subject to the scope of this Subtopic.
-
A transferor may transfer fixed-rate financial assets to a transferee and guarantee a variable-rate return. If the transfer is accounted for as a sale and an interest-rate swap is entered into as part of the contractual provisions of the transfer, the transferor records the interest rate swap as one of the financial components. In that case, the interest rate swap should be accounted for separately in accordance with this Subtopic. However, if the transfer is accounted for as a financing, the transferor records on its balance sheet the issuance of variable-rate debt and continues to report the fixed-rate financial assets; no derivative instrument is recognized under this Subtopic.
-
In a securitization transaction, a transferor transfers $100 of fixed-rate financial assets and the contractual terms of the beneficial interests incorporate an interest rate swap with a notional principal of $1 million. If the transfer is accounted for as a sale and the interest rate swap is entered into as part of the contractual provisions of the transfer, the transferor identifies and records the interest rate swap as one of the financial components. In that case, the interest rate swap would be accounted for separately in accordance with this Subtopic. However, if the transfer is accounted for as a financing, the transferor records in its balance sheet a $100 variable-rate borrowing and continues to report the $100 of fixed-rate financial assets. In this instance, because the liability is leveraged, requiring computation of interest flows based on a $1 million notional amount, the liability (which does not meet the definition of a derivative instrument in its entirety) is a hybrid instrument that contains an embedded derivative — such as an interest rate swap with a notional amount of $999,900. That embedded derivative is not clearly and closely related to the host contract under Section 815-15-25 (see paragraph 815-15-25-1[c]) because it could result in a rate of return on the counterparty’s asset that is at least double the initial rate and that is at least twice what otherwise would be the then-current market return for a contract that has the same terms as the host contract and that involves a debtor with credit quality similar to the issuer’s credit quality at inception. Therefore, the derivative instrument must be recorded separately under paragraph 815-15-25-1.
Certain instruments that hinder sale accounting are exempt from the scope of ASC
815. As an example, if a call option prevented a transfer of receivables from
being accounted for as a sale under ASC 860, the call option would be excluded
from ASC 815 and the transfer would be accounted for under ASC 860 as a
financing.
If a derivative instrument held by a transferor is related to
assets transferred in a transaction accounted for as a financing under ASC 860
but it does not itself serve as an impediment to sale accounting, the derivative
is not subject to the requirements of ASC 815 if recognizing both the derivative
instrument and either the transferred asset or the liability arising from the
transfer would result in counting the same item twice in the transferor’s
balance sheet. However, such derivative would be subject to the requirements of
ASC 815 if recognizing both the derivative and either the transferred asset or
liability does not result in double counting in the transferor’s balance
sheet.
2.3.7 Investments in Life Insurance
ASC 815-10
15-67 A
policyholder’s investment in a life insurance contract
that is accounted for under Subtopic 325-30 is not
subject to this Subtopic. This scope exclusion does not
affect the accounting by the issuer of the life
insurance contract.
While issuers of life insurance contracts are subject to the requirements of ASC
815-10, a policyholder’s investment in a life insurance contract is specifically
excluded from its scope.
2.3.8 Certain Investment Contracts
ASC 815-10
15-68 A
contract that is accounted for under either paragraph
960-325-35-1 or 960-325-35-3 is not subject to this
Subtopic. This scope exception applies only to the party
that accounts for the contract under Topic 960.
15-68A The
wrapper of a synthetic guaranteed investment contract
that meets the definition of a fully benefit-responsive
investment contract that is held by an employee benefit
plan is excluded from the scope of this Subtopic.
A contract that is accounted for under either ASC 960-325-35-1 or ASC
960-325-35-3 is not subject to ASC 815. The scope exception applies only to the
party that accounts for the contract under ASC 960.
2.3.9 Certain Loan Commitments
ASC 815-10
15-69 For the
holder of a commitment to originate a loan (that is, the
potential borrower), that commitment is not subject to
the requirements of this Subtopic. For issuers of
commitments to originate mortgage loans that will be
held for investment purposes, as discussed in paragraphs
948-310-25-3 through 25-4, those commitments are not
subject to this Subtopic. In addition, for issuers of
loan commitments to originate other types of loans (that
is, other than mortgage loans), those commitments are
not subject to the requirements of this Subtopic.
15-70 The
preceding paragraph does not affect the accounting for
commitments to purchase or sell mortgage loans or other
types of loans at a future date. Those types of loan
commitments must be evaluated under the definition of a
derivative instrument to determine whether this Subtopic
applies.
15-71
Notwithstanding the characteristics discussed in
paragraph 815-10-15-83, loan commitments that relate to
the origination of mortgage loans that will be held for
sale, as discussed in paragraph 948-310-25-3, shall be
accounted for as derivative instruments by the issuer of
the loan commitment (that is, the potential lender).
A loan commitment (i.e., an agreement to lend a specified amount of money during
a specified period in the future) generally would fail to meet the definition of
a derivative because it does not provide for net settlement. However, some loan
commitments contain assignment clauses or provide for delivery of an asset that
is RCC and would meet the definition of a derivative.
ASC 815-10-15-69 provides a scope exception under which the “holder of a
commitment to originate a loan” (the potential borrower in the arrangement) need
not account for a loan commitment as a derivative. In the case of a borrower,
the loan commitment scope exception applies to commitments to originate all
types of loans, both mortgage and nonmortgage loans. As noted in ASC
815-10-15-70, the guidance in ASC 815-10-15-69 should not be applied to
commitments to purchase or sell loans on a future date.
The issuer’s accounting for a loan commitment depends on several factors,
including the type of loan to be funded, the issuer’s intent and elections, and
whether industry-specific guidance applies. In evaluating the appropriate
accounting for the commitment, an issuer should consider the following
questions:
-
Must the commitment be accounted for as a derivative? Commitments to originate mortgage loans that will be held for sale must be accounted for as derivatives at fair value (see ASC 815-10-15-71 and SAB 105, codified as SAB Topic 5.DD8).
-
Has the fair value option been elected? The issuer of a loan commitment is permitted to elect the fair value option for the commitment (see ASC 825-10-15-4(c)). Loan commitments for which the fair value option has been elected are measured at fair value, with changes in fair value recognized in earnings. (See Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for additional discussion.)
-
Does industry-specific guidance apply? In some industries, issuers account for financial instruments, including loan commitments, at fair value (e.g., broker-dealers that are subject to the AICPA Audit and Accounting Guide Brokers and Dealers in Securities).
-
Does the loan to be acquired meet the definition of a debt security? The accounting for forward (and purchased option) contracts to acquire debt securities is addressed in ASC 815-10-25-17 and ASC 815-10-15-141. That guidance requires that forward contracts to acquire debt securities (other than forwards required to be accounted for as derivatives) be classified and accounted for in a manner consistent with ASC 320. Accordingly, the accounting for changes in the value of such forward contracts depends on whether the debt securities to be acquired will be classified as trading, available for sale (AFS), or held to maturity (HTM).
-
Does the entity intend to sell the loan to be funded or hold it for investment? If the loan to be funded is not a debt security and the loan commitment is not required to be accounted for at fair value under ASC 815, ASC 825, or industry-specific guidance, the accounting depends on whether the entity intends to hold the loan to be funded for sale or investment, as follows:
-
Loans held for sale — A white paper issued by the CAQ in October 2007 identifies two acceptable accounting policy alternatives if the entity intends to hold the loan for sale:
-
Alternative A — Entities may use a lower-of-cost-or-market model to account for the commitment by analogy to ASC 815. Under this approach, the terms of the committed loan are compared with current market terms; if the terms of the committed loan are below market, a loss is recorded to reflect the current fair value of the commitment.
-
Alternative B — Entities may account for the commitment under ASC 450-20. Under this approach, an entity assesses whether a loss is probable and reasonably estimable. If it is probable that the loan will be (1) funded under the terms of the commitment and (2) held for sale at a loss, the entity should measure the loss on the basis of the current fair value of the commitment.
For commitments to fund loans held for sale, any losses are measured on the basis of the current fair value of the commitment under both Alternative A and Alternative B. To determine fair value, an entity considers both interest rate risk and credit risk. For instance, even though it may not be probable that a credit loss has been incurred, a decline in fair value may have occurred if interest rates or credit spreads have increased after the issuance of the loan commitment (note that under Alternative B, the decline would be recognized only if both conditions above are satisfied). -
-
Loans held for investment — If the entity intends to hold the loan for investment (i.e., for the foreseeable future), the loan commitment should be evaluated for credit losses if it is within the scope of ASC 326-20. (See Section 2.1.1 of Deloitte’s Roadmap Current Expected Credit Losses for more information on evaluating whether unfunded loan commitments are within the scope of ASC 326-20.)
-
2.3.9.1 Mandatory Sales Contracts Versus “Best Efforts” Sales Contracts
An entity may also enter into a commitment to purchase or sell loans on a
future date. There are two different types of forward loan sale contracts:
-
Mandatory sales contracts.
-
“Best-efforts” sales contracts.
In a mandatory sales contract, an entity must deliver the stated notional
amount of loans. Any shortfall in the loans delivered results in the payment
of a penalty based on the amount of the shortfall (i.e., on the market value
of the undelivered loans). In a best-efforts contract, there is no penalty
for nonperformance.
A mandatory sales contract will meet the definition of a derivative if it
satisfies any of the net settlement criteria in ASC 815-10-15-99. Forward
loan sale contracts typically do not permit explicit net settlement (ASC
815-10-15-99(a)). Therefore, an entity should consider whether there is a
market mechanism that facilitates net settlement of the forward loan sale
contract or whether the loans underlying the forward loan sale contract are
RCC. Note that although an entity must analyze the loans subject to the
forward loan sale contract to determine whether the RCC net settlement
criterion is satisfied, the evaluation of whether a market mechanism exists
should be made with respect to the forward loan sale contract. ASC
815-10-15-70 clarifies that an entity should not analogize to the guidance
on loan commitments in ASC 815-10-15-69.
Some best-efforts sales contracts obligate the originator
(seller) to deliver and the buyer to purchase all originated loans that meet
certain criteria. However, if no loans are originated, there is no penalty
for nonperformance. These types of contracts are similar to contingent
forward sale contracts. At inception of such a contract, until loan
commitments are made for qualifying loans, there is no notional amount and
the contract does not meet the definition of a derivative. If and when a
qualifying loan commitment is made, a notional amount exists and the
contract may meet the definition of a derivative. However, the fair value of
the contract will be affected by the probability that the existing loan
commitments will result in originated loans.
Other best-efforts sales contracts only obligate the buyer to purchase
qualifying loans delivered by the originator (seller) and do not obligate
the originator to deliver any loans under the contract. These types of
contracts are more option-like. If a notional amount can be established and
the contract meets any of the net settlement criteria in ASC 815-10-15-99,
the contract represents an option written by the buyer to the originator
(seller), which meets the definition of a derivative.
2.3.9.2 Exercise or Expiration of a Loan Commitment Accounted for as a Derivative
Upon a mortgage banker’s exercise of a derivative loan commitment and
origination of a mortgage loan, the mortgage banker should derecognize the
derivative loan commitment and recognize the originated mortgage loan
initially at cost, which includes the fair value of the derivative loan
commitment that is extinguished on the origination of the loan. Accordingly,
the initial carrying amount of the loan is the net amount of the (1) actual
loan proceeds, (2) net fees and costs recognized in accordance with ASC
310-20, and (3) fair value of the derivative loan commitment immediately
before exercise (i.e., the derivative loan commitment should be remeasured
at fair value just before exercise, with any changes recognized in
earnings). Any difference between the loan’s contractual principal amount
and adjusted carrying amount should be recognized over the life of the loan
in accordance with the provisions of ASC 310-20.
Upon expiration of a loan commitment that has been accounted for as a
derivative, the mortgage banker should derecognize the carrying amount of
the derivative loan commitment, and the extinguished amount should be
recognized in earnings.
2.3.10 Certain Interest-Only Strips and Principal-Only Strips
ASC 815-10
Interests in Securitized Financial Assets
15-11 The
holder of an interest in securitized financial assets
(other than those identified in paragraphs 815-10-15-72
through 15-73) shall determine whether the interest is a
freestanding derivative instrument or contains an
embedded derivative that under Section 815-15-25 would
be required to be separated from the host contract and
accounted for separately.
15-72 An
interest-only strip or principal-only strip is not
subject to the requirements of this Subtopic provided
the strip has both of the following characteristics:
-
It represents the right to receive only a specified proportion of the contractual interest cash flows of a specific debt instrument or a specified proportion of the contractual principal cash flows of that debt instrument.
-
It does not incorporate any terms not present in the original debt instrument.
15-73 An
allocation of a portion of the interest or principal
cash flows of a specific debt instrument as reasonable
compensation for stripping the instrument or to provide
adequate compensation to a servicer (as defined in Topic
860) would meet the intended narrow nature of the scope
exception provided in this paragraph. However, an
allocation of a portion of the interest or principal
cash flows of a specific debt instrument to provide for
a guarantee of payments, for servicing in excess of
adequate compensation, or for any other purpose would
not meet the intended narrow nature of the scope
exception.
ASC 815-10-15-72 provides a narrow exception from ASC 815 for the simplest
interest-only (IO) and principal-only (PO) strips. Strips meeting the criteria
in ASC-815-10-15-72 are not subject to the requirements of ASC 815.
An entity must analyze a senior interest in a securitization transaction to
determine whether it contains one or more embedded derivatives (unless the
entire interest is recorded at fair value, with changes in fair value reported
in earnings). Accordingly, unless it meets the criteria for the ASC 815-10-15-72
exemption, an entity must consider potential ASC 815-15 ramifications for all
interests in securitized financial assets issued or acquired. See Chapter 4 for further discussion of embedded
derivatives.
Under ASC 815-15-25-1, the evaluation of whether a beneficial interest includes
an embedded derivative involves an analysis of the implicit and explicit terms
of the beneficial interest that affect some or all of the cash flows or value of
the interest in a manner similar to a derivative instrument. The analysis begins
with the explicit contractual terms of the beneficial interest such as interest
rate, maturity, payment priority, and payoff structure. However, it is also
necessary to understand the nature and amount of assets, liabilities, and other
financial instruments included in the securitization vehicle.
If the terms of the beneficial interest do not indicate that an embedded
derivative exists and the underlying financial instruments held by the
securitization vehicle will provide the necessary cash flows (excluding
credit-related shortfalls), a beneficial interest in a vehicle that holds one or
more derivative instruments would not necessarily indicate the existence of an
embedded derivative. As demonstrated in the cases in ASC 815-15-55-222 (currency
swap) and ASC 815-15-55-223 (interest rate swap), the inclusion of a derivative
instrument in a securitization vehicle may eliminate a mismatch in a
securitization structure that would otherwise result in an embedded
derivative.
2.3.10.1 Interest-Only and Principal-Only Strips Arising From Pools of Loans or Mortgage-Backed Securities
In limited circumstances, IO and PO strips that arise from pools of loans or
mortgage-backed securities (MBSs) can qualify for the scope exception.
However, only principal and interest strips resulting from the simplest
separation of cash flows are eligible. Specifically, as indicated in ASC
815-10-15-72, an IO or PO strip is exempt from ASC 815-15 only when it has
both of the following characteristics:
-
It represents the right to receive only a specified proportion of the contractual interest cash flows of a specific debt instrument or a specified proportion of the contractual principal cash flows of that debt instrument. [Emphasis added]
-
It does not incorporate any terms not present in the original debt instrument.
If pools of loans are aggregated in a securitization, IO and PO strips from
that securitization are exempt from ASC 815 if the above requirements are
satisfied. It does not matter whether the cash flows are derived from a
specific debt instrument or a pool of debt instruments as long as the
separation does not contain any terms that were not present in the original
debt instruments. Further, ASC 815-10-15-73 excludes from the exemption in
ASC 815-10-15-72 any IO or PO strip that is issued in connection with a
resecuritization of financial assets when the cash flows on the underlying
assets are used to pay (1) guarantee fees or (2) more than adequate
compensation to a servicer, as defined in ASC 860-50.
Example 2-15
IO and PO Strips That Meet the Scope
Exception
An insurance company securitizes a pool of “vanilla”
commercial loans it has originated in a nonrevolving
securitization. The loans do not embed any
derivatives that would require bifurcation under ASC
815 and the securitization vehicle holds no other
positions. The securitization vehicle issues IO and
PO strips to third-party investors as follows:
-
The investor in the IO strip is entitled to 100 percent of the interest payments on the underlying loans but not to principal payments.
-
The investor in the PO strip is entitled to 100 percent of the principal payments on the underlying loans but not to interest payments.
The IO and PO strips meet the exemption in ASC
815-10-15-72 because (1) the cash flows are used for
no purpose other than to support the IO and PO
strips, (2) the cash flows supporting the IO and PO
strips are fixed and determinable, (3) there are no
modifications to the underlying cash flows, and (4)
the securitization does not involve the payment of a
guarantee fee or servicing in excess of adequate
compensation.
Example 2-16
IO and PO Strips That Do Not Meet the Scope
Exception
A government-sponsored agency issues an IO strip and
a PO strip backed by a fixed-rate MBS that it has
guaranteed (e.g., a FNMA Mega or a FHLMC Giant). An
investor in the IO strip is entitled to 100 percent
of the interest payments but not to principal
payments from the underlying MBS. The investor in
the PO strip receives 100 percent of the principal
payments but does not receive any interest payments
from the underlying MBS. Because the mortgages
underlying the MBS were securitized in earlier
transactions involving the payment of guarantee
fees, the IO and the PO strips would not meet the
exemption in ASC 815-10-15-72 and would not be
exempt from the provisions of ASC 815 (i.e., they
must be analyzed to determine whether each is a
freestanding derivative or embeds a derivative in
accordance with ASC 815-15-25-1).
Example 2-17
IO and PO Strips With Contingent Features
An IO strip in a pool of loans contains a contingent
feature that reallocates a portion of the future
principal payments on the original financial
instruments to holders of the IO strip if interest
rates decline by a specified amount. Because the IO
and PO strips both contain contingent features, they
would not meet the exemption in ASC 815-10-15-72 and
therefore would not be exempt from the provisions of
ASC 815 (i.e., they must be analyzed to determine
whether each is a freestanding derivative or embeds
a derivative in accordance with ASC
815-15-25-1).
If an IO or PO strip does not meet the scope exception in ASC 815-10-15-72,
the entity is required to evaluate whether the financial instrument is a
freestanding derivative instrument or contains an embedded derivative that
otherwise would have to be accounted for separately as a derivative in
accordance with ASC 815-15-25-1. If the entity determines that an embedded
derivative meets the conditions in ASC 815-15-25-1, it may either (1)
account for the embedded derivative separately from the host contract or (2)
elect to measure the entire instrument at fair value under ASC 815-15-25-4
if the embedded derivative would have to be accounted for separately from
the host without this election.
2.3.10.2 Guarantee Fees and Servicing Fees Greater Than Adequate Compensation
As noted previously, only principal and interest strips resulting from the
simplest separation of cash flows are eligible for the exemption provided in
ASC 815-10-15-72. The separated cash flows cannot contain any terms that
were not present in the original debt instruments. Further, ASC 815-10-15-73
excludes from the exemption in ASC-815-10-15-72 any IO or PO strip that is
issued in connection with a securitization of financial assets if the cash
flows on the underlying assets are also used to pay guarantee fees or to pay
a servicer more than adequate compensation, as defined in ASC 860-50. Thus,
unless the investor intends to classify the security as a trading security
in accordance with ASC 320-10-25-1, an IO or PO strip investor who is
unrelated to the servicer will have to analyze whether (1) there is a
guarantee of payments involving the trust assets or (2) the fee paid to a
servicer represents more than adequate compensation.
Example 2-18
Servicing Fees in Excess of Adequate
Compensation
A securitization trust owns mortgage loans. The
servicing agreement entitles the servicer, who is
also the transferor, to more than adequate
compensation. In accordance with ASC 860-50, the
transferor/servicer records a servicing asset
representing the excess of the fair value of its
servicing fees over adequate compensation. Among the
interests that the trust issues is an IO strip
entitled to 50 basis points on the outstanding
principal amount of the securities in the trust and
an interest entitled to 100 percent of the principal
payments and contractual interest payments from the
underlying mortgage loans (net of payments related
to the IO and servicing). Because the servicing
agreement provides for servicing fees in excess of
adequate compensation, the IO strip would not be
exempt from the provisions of ASC 815 (i.e., it must
be analyzed to determine whether it is a
freestanding derivative or embeds a derivative in
accordance with ASC 815-15-25-1).
2.3.11 Certain Contracts Involving an Entity’s Own Equity
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:
-
Contracts issued or held by that reporting entity that are both:
-
Indexed to its own stock (see Section 815-40-15)
-
Classified in stockholders’ equity in its statement of financial position (see Section 815-40-25).
-
-
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.
-
Any of the following contracts:
-
A contract between an acquirer and a seller to enter into a business combination
-
A contract to enter into an acquisition by a not-for-profit entity
-
A contract between one or more NFPs to enter into a merger of not-for-profit entities.
-
-
Forward contracts that require settlement by the reporting entity’s delivery of cash in exchange for the acquisition of a fixed number of its equity shares (forward purchase contracts for the reporting entity’s shares that require physical settlement) that are accounted for under paragraphs 480-10-30-3 through 30-5, 480-10-35-3, and 480-10-45-3.
15-75 The scope exceptions in
paragraph 815-10-15-74 do not apply to either of the
following:
-
The counterparty in those contracts. For example, the scope exception in (b) in the preceding paragraph related to share-based compensation arrangements does not apply to equity instruments (including stock options) received by nonemployees as compensation for goods and services.
-
A contract that an entity either can or must settle by issuing its own equity instruments but that is indexed in part or in full to something other than its own stock. That contract can be a derivative instrument for the issuer under paragraphs 815-10-15-13 through 15-139, in which case it would be accounted for as a liability or an asset in accordance with the requirements of this Subtopic. For example, a forward contract that is indexed to both an entity’s own stock and currency exchange rates does not qualify for the exception in (a) in the preceding paragraph with respect to that entity’s accounting because the forward contract is indexed in part to something other than that entity’s own stock (namely, currency exchange rates).
15-75A For purposes of
evaluating whether a financial instrument meets the
scope exception in paragraph 815-10-15-74(a)(1), a down
round feature shall be excluded from the consideration
of whether the instrument is indexed to the entity’s own
stock.
15-76 Temporary equity is
considered stockholders’ equity for purposes of the
scope exception in paragraph 815-10-15-74(a) even if it
is required to be displayed outside of the permanent
equity section.
15-77 For guidance on
determining whether a freestanding financial instrument
or embedded feature is not precluded from qualifying for
the first part of the scope exception in paragraph
815-10-15-74(a), see the guidance beginning in paragraph
815-40-15-5. For guidance on determining whether a
freestanding financial instrument or embedded feature
qualifies for the second part of the scope exception in
paragraph 815-10-15-74(a), see the guidance beginning in
paragraph 815-40-25-1.
15-78 Paragraph 815-40-25-39
explains that, for purposes of evaluating under this
Subtopic whether an embedded derivative indexed to an
entity’s own stock would be classified in stockholders’
equity if freestanding, the additional considerations
necessary for equity classifications beginning in
paragraph 815-40-25-7 do not apply if the hybrid
contract is a convertible debt instrument in which the
holder may only realize the value of the conversion
option by exercising the option and receiving the entire
proceeds in a fixed number of shares or the equivalent
amount of cash (at the discretion of the issuer).
One of the most commonly evaluated scope exceptions involves certain contracts on
an entity’s own equity. For example, an entity may issue (1) warrants that it
can exercise into its own equity or (2) a convertible preferred stock or
convertible debt instrument that contains embedded conversion features that are
settleable in shares of its own equity.
These freestanding instruments or embedded features may otherwise meet the
definition of a derivative before consideration of whether the scope exception
in ASC 815-10-15-74(a) applies. See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for a
comprehensive discussion of the relevant guidance.
2.3.12 Leases
ASC 815-10
15-79 Leases
that are within the scope of Topic 842 are not
derivative instruments subject to this Subtopic,
although a derivative instrument embedded in a lease may
be subject to the requirements of paragraph
815-15-25-1.
ASC 815 provides a scope exception for leases that are in the scope of ASC 842,
and therefore lease contracts are not accounted for as freestanding derivative
instruments. However, lease contracts need to be analyzed to determine whether
they include embedded derivatives that require separate accounting.
Components of a lease agreement that might be considered embedded derivatives
include, but are not limited to:
-
Option arrangements, such as purchase or renewal options.
-
Indexed rental payments.
-
Additional rental payments that are contingent on the occurrence of an outside event or achievement of a certain threshold.
-
Rental payments denominated in a foreign currency.
The terms of any lease arrangement containing these or similar provisions must be
analyzed to determine whether the provision meets the definition of a derivative
and, if so, whether ASC 815 requires separate accounting for the embedded
derivative.
See Section 2.3.2 of Deloitte’s Roadmap
Leases for additional
discussion on this topic.
2.3.13 Residual Value Guarantees
ASC 815-10
15-80
Residual value guarantees that are subject to the
requirements of Topic 842 on leases are not subject to
the requirements of this Subtopic.
15-81 A
third-party residual value guarantor shall consider the
guidance in this Subtopic for all residual value
guarantees that it provides to determine whether they
are derivative instruments and whether they qualify for
any of the scope exceptions in this Subtopic. The
guarantees described in paragraph 842-10-15-43 for which
the exceptions of paragraphs 460-10-15-7(b) and
460-10-25-1(a) do not apply are subject to the initial
recognition, initial measurement, and disclosure
requirements of Topic 460.
Residual value guarantees that are accounted for under ASC 842, including any
residual value guarantee between the lessee and the lessor, are not subject to
the derivative accounting guidance in ASC 815-10. However, a third-party
guarantor must assess whether any residual value guarantee that it writes on an
underlying leased asset is subject to the guidance in ASC 815-10.
A leased asset subject to a third-party residual value guarantee will always be a
nonfinancial asset (i.e., financial assets cannot be leased). Accordingly, a
third-party guarantor may seek to avoid fair value measurement of the guarantee
and instead use the scope exception in ASC 815-10-15-59(b) for contracts that
are not traded on an exchange and are settled on the basis of the price or value
of a nonfinancial asset. Third-party guarantors will generally meet the second
condition in ASC 815-10-15-59(b) because increases in the fair market value of
the underlying nonfinancial asset reduce the third-party guarantor’s exposure
and, therefore, the asset’s owner would not benefit from such an increase in
value under the contract.
2.3.14 Registration Payment Arrangements
ASC Master Glossary
Registration Payment Arrangement
An arrangement with both of the following
characteristics:
- It specifies that the issuer will endeavor to do
either of the following:
-
File a registration statement for the resale of specified financial instruments and/or for the resale of equity shares that are issuable upon exercise or conversion of specified financial instruments and for that registration statement to be declared effective by the U.S. Securities and Exchange Commission (SEC) (or other applicable securities regulator if the registration statement will be filed in a foreign jurisdiction) within a specified grace period
-
Maintain the effectiveness of the registration statement for a specified period of time (or in perpetuity).
-
-
It requires the issuer to transfer consideration to the counterparty if the registration statement for the resale of the financial instrument or instruments subject to the arrangement is not declared effective or if effectiveness of the registration statement is not maintained. That consideration may be payable in a lump sum or it may be payable periodically, and the form of the consideration may vary. For example, the consideration may be in the form of cash, equity instruments, or adjustments to the terms of the financial instrument or instruments that are subject to the registration payment arrangement (such as an increased interest rate on a debt instrument).
ASC 815-10
15-82
Registration payment arrangements within the scope of
Subtopic 825-20 are not subject to the requirements of
this Subtopic. The exception in this paragraph applies
to both the issuer that accounts for the arrangement
pursuant to that Subtopic and the counterparty.
A registration payment arrangement within the scope of ASC 825-20 should not be
evaluated under ASC 815. Instead, it is accounted for as a separate unit of
account under ASC 825-20. See Section
3.3.3.2 of Deloitte’s Roadmap Issuer’s Accounting for Debt for additional
discussion on this topic.
Example 2-19
Registration Payment Arrangement Scope
Exception
Company Y, a publicly traded entity, owns and operates
gaming and racing facilities in the United States. On
May 1, 20X0, Y issues $330 million of convertible senior
notes that are due in 2026. The notes were not
registered under the Securities Act and were offered in
a private placement to QIBs under Rule 144A of the
Securities Act.
The notes bear interest at a rate of 2.75 percent per
year. Interest is payable semiannually in arrears on May
1 and November 1 of each year, commencing November 1,
20X0.
Company Y agrees to seek registration of 3.5 million
shares of Y’s common stock. If Y is unable to fulfill
its registration commitment by October 31, 20X0 (i.e.,
there is a “registration lapse”), the interest rate will
increase by 0.50 percent per annum in each successive
six-month period of noncompliance, capped at 5.0 percent
per annum.
The requirement to pay additional interest upon a
registration lapse represents a registration payment
arrangement that, in this fact pattern, is not subject
to any of the scope exceptions in ASC 825-20-15-4.
Therefore, the additional interest feature is within the
scope of ASC 825-20.
Arrangements within the scope of ASC
825-20 should be accounted for separately on the basis
of the recognition and measurement principles of ASC
450-20 at inception, and subsequently thereafter. That
is, amounts payable under the additional interest
feature should be recognized if those amounts are
probable and reasonably estimable. Specifically, ASC
825-20 states the following:
30-1 An entity shall
measure a registration payment arrangement as a
separate unit of account from the financial
instrument(s) subject to that arrangement.
30-3 The contingent
obligation to make future payments or otherwise
transfer consideration under a registration
payment arrangement shall be measured separately
in accordance with Subtopic 450-20.
30-4 If the transfer of
consideration under a registration payment
arrangement is probable and can be reasonably
estimated at inception, the contingent liability
under the registration payment arrangement shall
be included in the allocation of proceeds from the
related financing transaction using the
measurement guidance in Subtopic 450-20. The
remaining proceeds shall be allocated to the
financial instrument(s) issued in conjunction with
the registration payment arrangement based on the
provisions of other applicable GAAP. A financial
instrument issued concurrently with a registration
payment arrangement might be initially measured at
a discount to its principal amount under this
allocation methodology. For example, if the
financial instruments issued concurrently with the
registration payment arrangement are a debt
instrument and an equity-classified warrant, the
remaining proceeds after recognizing and measuring
a liability for the registration payment
arrangement under that Subtopic would be allocated
on a relative fair value basis between the debt
and the warrant pursuant to paragraph
470-20-25-3.
35-1 If the transfer of
consideration under a registration payment
arrangement becomes probable and can be reasonably
estimated after the inception of the arrangement
or if the measurement of a previously recognized
contingent liability increases or decreases in a
subsequent period, the initial recognition of the
contingent liability or the change in the
measurement of the previously recognized
contingent liability (in accordance with Subtopic
450-20) shall be recognized in earnings.
2.3.15 Certain Fixed-Odds Wagering Contracts
ASC 815-10
15-82A
Fixed-odds wagering contracts for an entity operating as
a casino and for the casino operations of other entities
are within the scope of Topic 606 on revenue from
contracts with customers. See paragraph
924-815-15-1.
Certain fixed-odds wagering contracts that are accounted for as revenue
transactions by an entity with casino operations are eligible for a scope
exception under ASC 815.
Footnotes
1
See Section 1.4.3.4
for further discussion of how to determine whether
an asset qualifies as RCC.
2
Under U.S. GAAP, certain entities are required to use the trade-date
basis of accounting for securities that meet the definition of
regular-way security trades. Entities subject to such a requirement may
include investment companies (ASC 946-320-25-1), brokers and dealers
(ASC 940-320-25-1), depository and lending institutions (ASC
942-325-25-2), defined benefit pension plans (ASC 960-325-25-1), defined
contribution pension plans (ASC 962-325-25-1), and health and welfare
benefit plans (ASC 965-320-25-1).
3
We believe that only the buyer would be
required to evaluate its needs for the related assets. A
seller would not be required to assess the buyer’s needs
when determining whether the NPNS scope exception would
apply, although a seller should assess whether the
quantity of the contract would be expected to be sold in
the normal course of business.
4
See Section 1.4.1.2 for
additional guidance on the concept of notional amount.
5
Under ASC 815-10-15-30, contracts should not be considered normal
if they (1) “have a price based on an underlying that is not
clearly and closely related to the [electricity] being sold or
purchased” or (2) “are denominated in a foreign currency that
meets none of the criteria in paragraph 815-15-15-10(b).”
6
PJM territories now include all or parts of
Pennsylvania, New Jersey, Maryland, Delaware,
Ohio, Virginia, Kentucky, North Carolina, West
Virginia, Indiana, Michigan, and Illinois.
7
As noted in Section
2.3.12, leases are outside the scope of
ASC 815; however, features embedded within lease
contracts could still meet the definition of a
derivative, and such features may or may not
qualify for one of the scope exceptions provided
under ASC 815.
8
The guidance in SAB Topic 5.DD should be applied equally to
public and nonpublic companies.
Chapter 3 — Recognition and Measurement of Freestanding Derivatives
Chapter 3 — Recognition and Measurement of Freestanding Derivatives
3.1 Overview
The purpose of this chapter is to explain the accounting for
freestanding derivative instruments. Warrants, swaps, and forward contracts are some
common examples of contracts that could require accounting as freestanding
derivatives.
ASC 815-10
05-4 This Topic
requires that an entity recognize derivative instruments,
including certain derivative instruments embedded in other
contracts, as assets or liabilities in the statement of
financial position and measure them at fair value. If
certain conditions are met, an entity may elect, under this
Topic, to designate a derivative instrument in any one of
the following ways:
-
A hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk (referred to as a fair value hedge)
-
A hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk (referred to as a cash flow hedge)
-
A hedge of the foreign currency exposure of any one of the following:
-
An unrecognized firm commitment (a foreign currency fair value hedge)
-
An available-for-sale debt security (a foreign currency fair value hedge)
-
A forecasted transaction (a foreign currency cash flow hedge)
-
A net investment in a foreign operation.
-
A key underlying principle of ASC 815 is
that derivatives represent either assets or liabilities in
the statement of financial position, and those assets or
liabilities should be measured at fair value. The accounting
for changes in a derivative’s fair value (i.e., the gains
and losses derived from those changes) depends on the
intended use of the derivative and the resulting
designation.1
Footnotes
1
See also Deloitte’s Roadmap
Hedge Accounting for
authoritative and interpretive guidance on hedge
accounting.
3.2 Initial Recognition and Measurement
Derivatives within the scope of ASC 815 (that do not qualify for any scope exception)
must be recognized on the balance sheet as either assets or liabilities. Derivative
instruments are initially recognized at fair value, which is measured by using the
principles under ASC 820.
See Chapter 9 of Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value
Option) for additional discussion on this topic.
3.3 Subsequent Measurement
ASC 815-10
35-1 All
derivative instruments shall be measured subsequently at
fair value.
35-2 The
accounting for changes in the fair value (that is, gains or
losses) of a derivative instrument depends on whether it has
been designated and qualifies as part of a hedging
relationship and, if so, on the reason for holding it.
Subtopic 815-20 discusses the accounting for the gain or
loss on a derivative instrument that is designated as a
hedging instrument. Except as noted in the following
paragraph, the gain or loss on a derivative instrument not
designated as a hedging instrument shall be recognized
currently in earnings.
35-3 An entity
that does not report earnings as a separate caption in a
statement of financial performance (for example, a
not-for-profit entity [NFP] or a defined benefit pension
plan) shall recognize the gain or loss on a nonhedging
derivative instrument as a change in net assets in the
period of change.
Entities may enter into derivative contracts to hedge their exposure to various
economic risks as part of their risk management strategy. If certain criteria are
met, ASC 815 permits them to designate such derivatives in a qualified hedging
relationship, which affects the accounting for the associated hedging instrument and
hedged item. When hedge accounting is applied, entities may not need to immediately
recognize the gain or loss associated with the change in the derivatives’ fair
value. See Deloitte’s Roadmap Hedge
Accounting for a thorough discussion of the application of hedge
accounting.
Derivatives that are not designated in a qualified hedging relationship are accounted
for at fair value, with changes in fair value recognized in earnings. Because of the
nature and complexity of such instruments, entities often need to engage valuation
specialists to determine the fair value of their derivative contracts.2
As indicated in ASC 815-10-35-3, “[a]n entity that does not report earnings as a
separate caption in a statement of financial performance [should] recognize the gain
or loss on a nonhedging derivative instrument as a change in net assets in the
period of change.”
Footnotes
2
See Section 6.3.2 of Deloitte’s Roadmap
Hedge Accounting for
discussion of the income statement classification of gains and losses
related to derivatives that represent an economic hedge but are not in
qualifying hedge relationships.
3.4 Derecognition
ASC 815-10
40-1
Extinguishments of derivative instruments that are
liabilities are addressed by paragraph 405-20-40-1.
Transfers of derivative instruments that are financial
assets are addressed by Section 860-10-40.
40-2 Transfers of
assets that are derivative instruments and subject to the
requirements of this Subtopic but that are not financial
assets shall be accounted for by analogy to Subtopic 860-10.
This guidance is limited to transfers of nonfinancial assets
that are derivative instruments that are or will be subject
to the requirements of this Subtopic. An example would be a
transfer to another entity of a derivative instrument, such
as a forward contract to purchase gold that requires
physical settlement and is or will be subject to the
requirements of this Subtopic.
40-3 If a
derivative instrument has the potential to be both a
nonfinancial asset and a nonfinancial liability (such as a
commodity forward contract that is a nonfinancial derivative
instrument), then, as described in paragraph 860-10-40-40,
the criteria of both Sections 405-20-40 and 860-10-40 shall
be met to qualify for derecognition.
ASC 860-10
Application of the Sale
Criteria for Financial Instruments That Have the
Potential to Be Assets or Liabilities
40-40 Certain
recognized financial instruments, such as forward contracts
and swaps, have the potential to be financial assets or
financial liabilities. Accordingly, transfers of those
financial instruments must meet the conditions of both
paragraphs 405-20-40-1 and 860-10-40-5 to be derecognized.
Paragraph 815-10-40-2 states that transfers of assets that
are derivative instruments and subject to the requirements
of Subtopic 815-10 but that are not financial assets shall
be accounted for by analogy to this Subtopic. The same
criteria shall be applied to transfers of nonfinancial
derivative instruments that have the potential to become
either assets or liabilities (for example, forward contracts
and swaps).
The accounting model for evaluating whether to derecognize a derivative depends on
whether the instrument is an asset or a liability. Derivative instruments that are
liabilities would be evaluated for extinguishment on the basis of the guidance in
ASC 405-20, while derivative instruments that are assets would be evaluated for
derecognition on the basis of the guidance in ASC 860-10. Although the guidance in
ASC 860-10 only explicitly applies to the transfers and sales of derivative
instruments that meet the definition of a financial asset, it is appropriate for an
entity to analogize to such guidance when evaluating the transfer or sale of a
nonfinancial derivative asset.
Instruments that would have been accounted for as derivative instruments if it were
not for an applicable scope exception (see Chapter
2) would not be considered derivatives in the application of this
derecognition guidance.
Importantly, some derivative contracts have the potential to result in the
recognition of either a derivative asset or a derivative liability.3 ASC 860-10-40-40 specifies that to be derecognized, transfers of recognized
financial instruments that have the potential to be assets or liabilities, such as
certain derivatives, must meet the conditions for (1) sale accounting of financial
assets in ASC 860-10-40-5 and (2) extinguishment of liabilities in ASC 405-20-40-1.
This guidance also applies to transfers of nonderivative instruments that may be
assets or liabilities (e.g., forwards to acquire a commodity).
ASC 405-20
40-1 Unless
addressed by other guidance (for example, paragraphs
405-20-40-3 through 40-4 or paragraphs 606-10-55-46 through
55-49), a debtor shall derecognize a liability if and only
if it has been extinguished. A liability has been
extinguished if either of the following conditions is
met:
-
The debtor pays the creditor and is relieved of its obligation for the liability. Paying the creditor includes the following:
-
Delivery of cash
-
Delivery of other financial assets
-
Delivery of goods or services
-
Reacquisition by the debtor of its outstanding debt securities whether the securities are cancelled or held as so-called treasury bonds.
-
-
The debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor. For purposes of applying this Subtopic, a sale and related assumption effectively accomplish a legal release if nonrecourse debt (such as certain mortgage loans) is assumed by a third party in conjunction with the sale of an asset that serves as sole collateral for that debt.
As indicated above, ASC 405-20-40-1 identifies the two circumstances in which a
liability should be considered extinguished:
-
“The debtor pays the creditor and is relieved of its obligation.” For instance, an entity may settle all or a portion of a derivative liability by delivering cash, other financial assets, its own equity shares, goods, or services to the counterparty.
-
“The debtor is legally released [as] the primary obligor . . . either judicially or by the creditor.” For instance, a derivative liability may be extinguished through a court order, the counterparty forgiving the obligation, or the assumption of the obligation by a third party.
See Deloitte’s Roadmap Transfers and Servicing of
Financial Assets for further discussion of the application of
ASC 860.
Footnotes
3
For example, a fixed-price forward contract to purchase the underlying would
be recorded as a liability if the forward price is expected to be greater
than the fair value of the underlying; however, the same forward could
instead be recorded as an asset if the forward price is expected to be less
than the fair value of the underlying.
3.5 Reassessment
ASC 815-10
25-2 If a
contract that did not meet the definition of a derivative
instrument at acquisition by the entity meets the definition
of a derivative instrument after acquisition by the entity,
the contract shall be recognized immediately as either an
asset or liability with the offsetting entry recorded in
earnings.
25-3 If a
contract ceases to be a derivative instrument pursuant to
this Subtopic and an asset or liability had been recorded
for that contract, the carrying amount of that contract
becomes its cost basis and the entity shall apply other
generally accepted accounting principles (GAAP) that are
applicable to that contract prospectively from the date that
the contract ceased to be a derivative instrument. If the
derivative instrument had been designated in a cash flow
hedging relationship and a gain or loss is recorded in
accumulated other comprehensive income, then the guidance in
Sections 815-30-35 and 815-30-40 shall be applied
accordingly.
Contract That Is a
Derivative Instrument After Acquisition
30-3 A contract
recognized under paragraph 815-10-25-2 because it meets the
definition of a derivative instrument after acquisition by
an entity shall be measured initially at its then-current
fair value.
An entity should reevaluate its application of ASC 815 as of each reporting period.
This assessment should also occur at least quarterly or whenever the company
prepares financial statements for an external party (e.g., filing financial
statements with an exchange or providing financial statements to a bank for debt
covenant purposes).
If a financial instrument or a contract that did not initially meet the definition of
a derivative later meets that definition, an entity should recognize the instrument
as a derivative asset or a liability at its then current fair value. Alternatively,
if an instrument that was initially recognized as a derivative later ceases to meet
that definition, other guidance in U.S. GAAP applies.
An entity should also continually reassess whether an embedded feature qualifies as a
derivative and, if so, whether it qualifies for any derivative scope exception. See
Chapters 4, 5, and 6 for further discussion of embedded
derivatives.
Chapter 4 — Identification of and Accounting for Embedded Derivatives
Chapter 4 — Identification of and Accounting for Embedded Derivatives
4.1 Background
ASC 815-15
05-1
Contracts that do not in their entirety meet the definition
of a derivative instrument (see paragraphs 815-10-15-83
through 15-139), such as bonds, insurance policies, and
leases, may contain embedded derivatives. The effect of
embedding a derivative instrument in another type of
contract (the host contract) is that some or all of the cash
flows or other exchanges that otherwise would be required by
the host contract, whether unconditional or contingent on
the occurrence of a specified event, will be modified based
on one or more underlyings.
15-2 The
guidance in this Subtopic applies only to contracts that do
not meet the definition of a derivative instrument in their
entirety.
As noted in Section 1.3, an instrument that does not meet the
definition of a derivative in its entirety may contain contractual terms or features
that affect the cash flows, values, or other exchanges required by the terms of the
instrument in a manner similar to a derivative. Such contractual terms or features
are “embedded” in the instrument or contract and are referred to as “embedded
derivatives,” as defined in the ASC master glossary. Embedded derivatives that meet
all of the requirements for bifurcation are accounted for separately from their host
contract as if they were freestanding derivatives; that is, they are recorded at
fair value at the end of each reporting period, with changes in fair value generally
reported through earnings.
In developing the derivative accounting requirements that are now located in ASC 815
(such as the requirement to measure derivatives at fair value on a recurring basis),
the FASB concluded that an entity should not be able to circumvent those
requirements by incorporating derivatives in the contractual terms of nonderivative
contracts (e.g., outstanding debt, preferred stock). Accordingly, it decided that
derivatives that are embedded in the terms of nonderivative contracts should be
accounted for as derivatives separately from the contracts in which they are
embedded (i.e., host contracts) when certain criteria are met. An entity is thus
unable to avoid the recognition and measurement requirements of ASC 815 merely by
embedding a derivative instrument in a nonderivative financial instrument or other
contract.
The FASB also decided that not all embedded features need to be bifurcated from their
host contracts. Features that would not have met the definition of a derivative in
ASC 815 on a freestanding basis (see Section 4.3.4) or that
qualify for a derivative accounting scope exception (see Section
4.3.5) should not be bifurcated. Features that are embedded in
contracts that are accounted for in their entirety at fair value, with changes in
fair value recognized in earnings on a recurring basis, are also not bifurcated (see
Section 4.3.3). Further, features that have economic
characteristics and risks that are clearly and closely related to those of their
host contract are not bifurcated.
Accordingly, an entity must carefully evaluate the terms of outstanding hybrid
instruments to determine whether they contain any features that must be accounted
for as derivatives separately from their host contracts under ASC 815-15.
This chapter includes guidance on how to (1) identify embedded features, (2) evaluate
whether those features require bifurcation, and (3) account for bifurcated embedded
derivatives.
4.2 Identification of Embedded Features
4.2.1 General
ASC Master Glossary
Embedded
Derivative
Implicit or explicit terms that affect
some or all of the cash flows or the value of other
exchanges required by a contract in a manner similar to
a derivative instrument.
Hybrid
Instrument
A contract that embodies both an
embedded derivative and a host contract.
Embedded derivatives can result from both implicit and explicit terms that affect
the cash flows or the value of the contract in a manner similar to a derivative.
Although embedded derivatives are commonly identified in debt and equity
instruments, they may also exist in other contracts (e.g., leases, service
arrangements, insurance contracts). As a general rule, an entity should evaluate
whether a contract contains embedded derivatives (1) at inception or acquisition
of the contract, (2) whenever the contract’s terms change, and (3) when certain
events (such as an IPO) occur.
An instrument that contains embedded derivatives is referred to as a hybrid
instrument, which consists of both the host contract and the embedded
derivative(s).
The table below highlights common examples of embedded derivatives in certain
hybrid instruments.
Hybrid Instrument
|
Host Contract
|
Embedded Derivative
|
---|---|---|
Preferred stock
|
Equity or debt host
|
Conversion option
|
Preferred stock
|
Equity or debt host
|
Redemption option
|
Convertible debt
|
Debt host
|
Conversion option
|
Debt
|
Debt host
|
Contingent interest rate increase
|
Lease contract
|
Lease host
|
Variable payments based on the price of gold
|
Loan (receivable)
|
Debt host
|
Adjustments to interest rate based on entity sales
results
|
Features that are legally detachable and separately exercisable from a financial
instrument represent freestanding financial instruments; therefore, they are not
evaluated as embedded derivatives even if they are part of the same contract
(e.g., a freestanding warrant or loan commitment that is issued as part of the
contractual terms of a debt instrument). Such features are treated as separate
units of account since they meet the definition of a freestanding financial
instrument.
4.2.2 Payoff-Profile Approach to Identifying Embedded Derivatives
4.2.2.1 Background
To identify embedded derivatives, an entity should not rely solely on how
terms are described in the contractual provisions of an instrument; rather,
the entity should consider the economic payoff profile of the contractual
terms. Under the payoff-profile approach, the embedded features in a hybrid
instrument are identified on the basis of the monetary or economic value
that each feature conveys upon settlement (e.g., a feature that settles at a
fixed monetary amount is evaluated separately from a feature that settles at
an amount indexed to a specified underlying, such as the debtor’s stock
price). Embedded features with different payoff profiles are evaluated
separately. The payoff-profile approach to identifying embedded features is
consistent with the definition of an embedded derivative in ASC 815-15-20,
which focuses on how an implicit or explicit term affects the cash flows or
values of other exchanges required by a contract.
If an embedded feature’s economic payoff profile differs from how the
provision is described in the instrument’s contractual terms, an entity must
evaluate the feature on the basis of its payoff profile, not its contractual
form. For example, a term that is described as a conversion feature would be
evaluated as a redemption feature if, upon exercise, it represents a right
for the investor to receive a variable number of equity shares worth a fixed
monetary amount.
Further, the contractual conversion terms of a debt or
equity instrument might need to be separated into multiple features on the
basis of the nature of the payoff. For instance, depending on the
circumstances at conversion or the types of events that could trigger a
conversion, such terms might specify the delivery of either (1) a variable
number of the issuer’s equity shares with an aggregate fair value at
settlement equal to a fixed monetary amount (a share-settled redemption
feature) or (2) a fixed number of the issuer’s equity shares (an equity
conversion feature). It is therefore appropriate to separate the stated
conversion terms into a redemption feature and an equity conversion feature
even though they are described in the same contractual conversion provision.
However, a payment feature that can only be triggered upon the settlement of
another payment feature should generally be analyzed as part of the
settlement amount of that other payment feature even if it has a dissimilar
payoff. For example, an interest make-whole payment on a debt instrument
(such as a requirement to pay the present value of the remaining scheduled
interest payments if the debt instrument is settled early before its
maturity date) should be evaluated as part of an equity conversion feature
if it is payable only upon the exercise of that equity conversion feature.
In this scenario, the interest make-whole payment represents an adjustment
to the settlement amount of the equity conversion feature.
4.2.2.2 Features With Different Forms of Settlement
Different terms within a hybrid instrument that have the same economic payoff
profile may need to be evaluated on a combined basis even if they involve
different forms of settlement. For example, a convertible debt or equity
instrument might contain provisions related to the redemption and conversion
of the instrument in separate sections of the relevant legal agreements. If
triggered, the redemption provisions require settlement at an amount of cash
equal to the greater of a fixed monetary amount and the fair value of a
fixed number of the debtor’s equity shares. The conversion provisions
require settlement in a fixed number of the issuer’s equity shares. In this
example, the requirement to potentially redeem the instrument for cash at an
amount equal to the fair value of a fixed number of equity shares would be
analyzed as a part of the equity conversion feature (not as part of the
redemption feature). The requirement to potentially redeem the instrument
for cash at a fixed monetary amount would be evaluated as a redemption
feature.
4.2.2.3 Equity Conversion Features
Under the payoff-profile approach, an equity conversion feature (see
Section 6.2.2.2) generally is evaluated as a single
embedded feature even if it contains multiple exercise contingencies. The
equity conversion feature would not be split into embedded features for each
of the exercise contingencies if the payoff is similar for each of the
exercise contingencies. For example, a conversion feature that would result
in the delivery of a fixed number of the issuer’s equity shares upon
exercise might be exercisable in multiple circumstances, such as if the
instrument trades at a price below 98 percent of par, the common stock
trades at a price in excess of 120 percent of par, the issuer elects to call
the debt, or specified corporate transactions take place. Such a conversion
feature would be analyzed as one embedded conversion feature, not as
multiple conversion features.
In a manner consistent with the approach described above, an equity
conversion feature that may be exercised at any time at the holder’s option
would be combined with an equity conversion feature that is automatically
exercised upon the occurrence or nonoccurrence of a specified event when the
payoff profiles of such conversion features are the same. See also
Example 4-4.
4.2.2.4 Redemption Features
In the analysis of redemption features under the payoff-profile approach,
call options and put options are considered separate embedded derivatives
even if the redemption prices are the same. This is because the payoff
profile of a call option differs from the payoff profile of a put option
even when the redemption prices of the options are the same. If a debtor has
a right to redeem an outstanding debt instrument at its principal amount
(i.e., the right to call the instrument from the holder), it would be
economically motivated to exercise this option only if the fair value of the
debt exceeded its principal amount. However, if a creditor has the right to
force redemption of an outstanding debt instrument at its principal amount,
it would be economically motivated to exercise this option only if the fair
value of the debt was less than its principal amount. Given that the payoff
profiles of call options and put options differ and the holders of such
options are also different parties, a call option is never combined with a
put option and treated as a single embedded derivative under the
payoff-profile approach.
Noncontingent redemption features should be combined with
contingent redemption features when the payoff profiles are the same. For
example, if a debt instrument contains (1) a noncontingent put option that
allows the holder to force redemption at the instrument’s principal amount
upon the mere passage of time and (2) a contingent put option that allows
the holder to force redemption at the instrument’s principal amount upon the
occurrence of a downgrade in the issuer’s credit rating, the two put options
would represent a single combined embedded derivative since they share the
same payoff profile and are held by the same party to the instrument.
However, as discussed above, a noncontingent call option would not be
combined with a contingent put option even if the redemption prices of the
two options were the same. See Example
4-4 for an illustration of the identification of the units of
account for embedded redemption features.
Example 4-1
Preferred Stock With Various Redemption
Triggers
Entity R issues $100 million in preferred stock on
June 30, 20X2, that pays a dividend rate of 6
percent per annum. The preferred stock is redeemable
at its original issuance price plus accrued but
unpaid dividends upon the following events:
-
Holder option.
-
Change in control.
-
Sale of substantially all of R’s assets.
-
Majority vote of the preferred stockholders.
Even though there are four different triggering
events that could cause the redemption features to
be exercisable, the redemption feature would be
analyzed as a single unit of account because the
same payoff is associated with each trigger.
Example 4-2
Preferred Stock With a Dividend Step-Up
Feature
Assume the same facts as the previous example, except
that the preferred stock contains a feature in which
the dividend rate increases to 12 percent per annum
upon the occurrence of any default event (the
“dividend step-up feature”). A default event, as
defined in the share purchase agreement (SPA),
includes any change in control of Entity R, any
breach of contract terms under the SPA, a
liquidation or winding up of R, and the insolvency
of R. Under the payoff-profile approach, R should
evaluate the dividend step-up feature as a single
embedded feature despite the existence of multiple
triggers comprising a default event because the
dividend payoff is the same for each. Therefore, if
one trigger would result in the need to bifurcate
the dividend step-up feature in accordance with ASC
815-15-25-1, it does not matter whether other
triggers would result in bifurcation of the dividend
step-up feature if separately evaluated.
4.2.2.5 Features With Interdependent Payoff
Other features that have an interdependent payoff are evaluated on a combined
basis as a single embedded feature. For example, a debt instrument may
contain multiple additional interest provisions that specify a fixed
increase to the interest rate (e.g., 0.25 percent or 0.50 percent) upon the
occurrence of any of a number of specified events (e.g., an event of default
involving the debtor, the debtor’s late submission of its SEC filings, or
the holder’s inability to freely trade the instrument; see Section
6.10.1). If there is a contractual ceiling on the total
amount of additional interest that the debtor could be required to pay under
all of the additional interest provisions, each such additional interest
provision would be interdependent, because no incremental amount would be
payable once the ceiling is reached even if an event that otherwise would
trigger an additional interest payment were to occur. Accordingly, those
additional interest provisions would be evaluated on a combined basis as one
embedded interest feature. If any of the underlying events that would
trigger additional interest payments is not clearly and closely related to
the debt host, the combined additional interest feature would not be clearly
and closely related to the debt host even if additional interest provisions
individually would have been clearly and closely related to the debt host.
However, if additional interest provisions are independent (i.e., they are
additive), it may be appropriate to evaluate each one separately. That is,
the determination of whether an embedded derivative must be bifurcated might
differ for each individual additional interest feature depending on what
triggers it.
Connecting the Dots
Callable debt may contain a provision that requires the debtor to pay
a premium to the holder if it were to call the debt before its
maturity (see Example 6-5 for an illustration).
Such a provision might be called “an interest make-whole provision,”
a “change-in-control interest make-whole,” a “maintenance premium
payment,” a “maintenance call,” or a “lump-sum call payment.”
Regardless of its label, the feature would require the debtor, upon
exercise of the feature’s call option, to make a lump-sum payment to
the investor as compensation for future interest payments that will
not be paid because of the shortening of the outstanding life of the
instrument (e.g., the present value of the debt’s remaining interest
cash flows, discounted at a small spread over the then-current U.S.
Treasury rate). When an interest make-whole provision is triggered
by the exercise of a call option, the make-whole provision is
considered an integral component of the call option; it is not a
distinct embedded feature that must be separately evaluated under
ASC 815-15. See Section 6.4 for further
discussion of the evaluation of embedded call options in debt host
contracts.
Similarly, convertible debt may include a provision
that requires the conversion rate to be adjusted upon a fundamental
change transaction (such as a change of control) on the basis of a
make-whole table (see Section 4.3.7.9 of
Deloitte’s Roadmap Contracts on an Entity’s Own
Equity for an example). The purpose and
design of the table is to make the holder whole for lost time value
in the conversion option upon the early settlement of the debt. Such
a make-whole provision is evaluated as part of the conversion
option, not as a separate embedded feature.
Example 4-3
Loan With Interest That Varies on the Basis of the
Issuer’s Stock Market Capitalization
Company A entered into a loan agreement that contains
variable interest payments. The interest rate on the
loan is defined as a market-based variable component
(e.g., Secured Overnight Financing Rate [SOFR]) plus
an applicable margin. The applicable margin varies
on the basis of the issuer’s stock market
capitalization, as follows:
Market Capitalization
|
Applicable Margin
|
---|---|
Less than or equal to $10 billion
|
5.55%
|
Greater than $10 billion but less than or equal
to $15 billion
|
5.20%
|
Greater than $15 billion
|
4.85%
|
Because the applicable margin is additive to the
variable base rate, the issuer may identify it as an
embedded feature that is separate from the variable
base rate. Under this view, there are two embedded
features: (1) the variable base rate and (2) the
applicable margin. The variable base rate is
evaluated under ASC 815-15-25-26 because it is based
solely on interest rates (see Section
5.2.3). The applicable margin is
indexed to the issuer’s stock market capitalization
(which is an underlying other than an interest rate
or interest rate index; see Section
5.2.3), the debtor’s creditworthiness
(see Section 5.3.3), or
inflation (see Section 5.4.3).
Accordingly, this feature should not be evaluated
under ASC 815-15-25-26. It would be considered not
clearly and closely related to the debt host.
An entity is not permitted to identify embedded features that are not clearly
present in the hybrid instrument. For example, an entity is not permitted to
disaggregate a fixed-rate debt instrument into (1) a floating-rate debt
instrument and (2) an embedded interest rate swap that exchanges floating
interest payments for fixed interest payments.
4.2.3 Illustration of the Identification of Embedded Features
Example 4-4
Convertible Promissory Note With Various Embedded
Features
During the fiscal year ended December 31, 20X3, Entity X
issued $20 million of convertible promissory notes with
the following terms:
-
Interest — The notes carry a fixed rate of interest of 1 percent per annum.
-
Maturity date — The notes mature on the earlier of (1) June 30, 20X8, or (2) the date on which, upon the occurrence (and during the continuance) of an event of default, such amounts are declared due and payable by an investor or become automatically due and payable (see below).
-
Mandatory prepayment — In the event of a change of control of X, the outstanding principal amount of the notes and all accrued and unpaid interest on them are due and payable immediately before the closing of such change of control.
-
Automatic conversion — If X sells shares of its capital stock for aggregate gross proceeds of at least $40 million (a “qualified financing”) before the maturity date, the outstanding principal amount of the notes and all accrued and unpaid interest on them automatically convert into shares issued in such qualified financing at a price equal to the lesser of (1) the price per share paid by investors in the qualified financing and (2) the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
Voluntary conversion — Upon the election of a majority of the investors, the outstanding principal amount of the notes and all accrued and unpaid interest on them may be converted into shares of X’s capital stock issued in any equity financing for capital raising purposes at a price equal to the lesser of (1) the price per share paid by investors in such financing and (2) the quotient of $25 million and the amount of X’s fully diluted equity capital. If no qualified financing occurs on or before the maturity date, a majority of the investors can elect to convert the outstanding principal amount of the notes and all accrued and unpaid interest on them into shares of X’s preferred stock at a price per share equal to the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
Conversion upon a change of control — If a change of control occurs before a qualified financing, the investors may elect to convert the outstanding principal amount of the notes and all accrued and unpaid interest on the notes immediately before such change of control into shares of X’s common stock at a price per share equal to the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
Revenue-based payment feature — Entity X is required to make payments of up to $1 million each quarter based on 10 percent of all revenue over $10 million.
-
Rights of investors upon default — Upon the occurrence of an event of default (other than an event of default involving voluntary or involuntary bankruptcy or insolvency proceedings) and at any time thereafter during the continuance of such an event of default, a majority of the investors may elect to declare all outstanding obligations under the notes to be immediately due and payable. Upon the occurrence of any event of default involving voluntary or involuntary bankruptcy or insolvency proceedings, immediately and without notice, all outstanding obligations under the notes automatically become immediately due and payable. Investors also have the right to receive additional interest on the notes at a rate equal to 1 percent per annum of the principal amount of the notes outstanding for each day during the first 180 days after the occurrence of an event of default and 2 percent per annum of the principal amount of the notes outstanding from the 181st day following the occurrence of an event of default. All events of default represent credit-risk-related covenants (see Section 5.3.3).
Entity X is evaluating whether any embedded features must
be separated from the notes and accounted for as
derivatives under ASC 815-15. It has determined that the
notes should be analyzed as a debt host contract under
ASC 815-15 (see Section 4.3.2).
Under the payoff-profile approach, the notes contain the
following embedded features that should be evaluated
under ASC 815-15:
-
Contingent redemption features — The features below involve the contingent settlement of the notes for consideration of the same fixed monetary amount. Because each feature is contingent and settleable for the same monetary amount, X analyzes them under the guidance on call, put, and other redemption features (see Section 6.4):
-
If a qualified financing occurs before the maturity date, the outstanding principal amount of the notes and all accrued and unpaid interest on them automatically convert into shares of the capital stock issued in the qualified financing at a price no higher than the price paid per share by its investors in the qualified financing. Although this feature is settled in shares, the number of shares delivered under the feature varies on the basis of the fair value of those shares (i.e., price per share paid by the investors) so that the total fair value of those shares will equal the outstanding principal amount and accrued and unpaid interest on the notes regardless of changes in the fair value of the shares. Accordingly, this feature is effectively an early redemption of the notes that uses shares as “currency.” Entity X therefore analyzes it as a redemption feature under the monetary payoff-profile approach (see Section 4.2.2).
-
Upon the election of a majority of the investors, the outstanding principal amount of the notes and all accrued and unpaid interest on them may be converted into shares of X’s capital stock issued in any equity financing for capital raising purposes at a price no higher than the price per share paid by investors in such financing. Although this feature is settled in shares, the number of shares that may ultimately be delivered will vary on the basis of the fair value of those shares (i.e., price per share paid by the investors), such that the total fair value of those shares will equal the outstanding principal amount and accrued and unpaid interest on the notes regardless of changes in the fair value of the shares. Accordingly, this feature is effectively an early redemption of the notes that uses shares as “currency.” Entity X therefore analyzes it as a redemption feature under the monetary payoff-profile approach.
-
In the event of a change of control, the outstanding principal amount of each note that has not otherwise been converted into equity securities, plus all accrued and unpaid interest, is due and payable immediately before the closing of the change of control.
-
Upon the occurrence of an event of default and at any time thereafter during the continuance of such event, a majority of the investors may declare all outstanding obligations payable by X under the notes to be immediately due and payable, and such amounts automatically become due upon the occurrence of a voluntary or involuntary bankruptcy or insolvency proceeding of X.
-
-
Equity conversion feature — The following features have an equity-based return through conversion of the notes into X’s equity shares at a conversion price equal to the quotient of $25 million and the amount of X’s fully diluted equity capital. Because each feature has a payoff that is based on an equity return, X analyzes them as one combined embedded feature:
-
If a qualified financing occurs before the maturity date, the outstanding principal amount of the notes and all accrued and unpaid interest on the notes automatically convert into shares of the capital stock issued in the qualified financing at a price no higher than the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
Upon the election of a majority of the investors, the outstanding principal amount of the notes and all accrued and unpaid interest on the notes may be converted into shares of X’s capital stock issued in any equity financing for capital raising purposes at a price no higher than the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
If a qualified financing does not occur before the maturity date, the outstanding principal amount of the notes and all accrued and unpaid interest on them may be converted at the option of a majority of the investors into shares of X’s preferred stock at a price equal to the quotient of $25 million and the amount of X’s fully diluted equity capital.
- If a change of control occurs before a qualified financing, the investors may elect to convert the outstanding principal amount of the notes and all accrued and unpaid interest on them immediately before such change of control into shares of X’s common stock at a price per share equal to the quotient of $25 million and the amount of X’s fully diluted equity capital.
-
- Credit-sensitive payments — The right to receive additional interest on the notes at a rate equal to 1 percent per annum of the principal amount of the notes outstanding for each day during the first 180 days after the occurrence of an event of default and 2 percent per annum of the principal amount of the notes outstanding from the 181st day following the occurrence of an event of default represents an additional interest provision on the basis of a credit-related feature (see Section 5.3 for a discussion of the evaluation of such features).
- Revenue-based payment feature — The requirement to make payments of up to $1 million each quarter based on 10 percent of all revenue over $10 million is an additional interest provision on the basis of a revenue feature (see Section 6.9 for a discussion of the evaluation of such features).
Example 4-5
Preferred Stock With Various Embedded Features
During the fiscal year ended December 31, 20X3, Entity A
issued $100 million of convertible preferred stock with
the following terms:
-
Conversion option —The holder of the preferred stock may convert it at any time into common stock on a one-for-one basis (the “holder’s conversion option”).
-
Liquidation provision — In the event of any voluntary or involuntary liquidation, dissolution or winding up of A, or a change in control, the holders of the preferred stock are entitled to be paid out of the assets of A that are available for distribution to its stockholders, an amount per share equal to the greater of the following:
-
The original issuance price, plus any dividends declared but unpaid (the “liquidation redemption option”).
-
The amount per share that would have been payable had all shares of the preferred stock been converted into common stock immediately before such liquidation, dissolution, winding up, or change in control (the “liquidation in-substance conversion option”).
-
-
Dividends — The holder of the preferred stock is entitled to cumulative dividends at a rate of 8 percent per annum. The holder is entitled to cumulative dividends at a rate of 12 percent per annum if A triggers any of the default provisions described in the preferred stock agreement (the “default dividends”).
Entity A is evaluating whether any embedded features must
be separated from the preferred stock and accounted for
as derivatives under ASC 815-15. Under the
payoff-profile approach, the preferred stock contains
the following embedded features that should be evaluated
under ASC 815-15:
-
The conversion options — The holder’s conversion option and the liquidation in-substance conversion option (collectively, the “conversion options”) have the same payoff profile and would be evaluated together:
-
The liquidation in-substance conversion option — This gives the holder the right to receive an amount per share that would have been payable had all shares of the preferred stock been converted into common stock. The option should be evaluated as a conversion feature because the value of the cash received is equal to the fair value of the common stock underlying the conversion feature.
-
The holder’s conversion option — This would be evaluated as a conversion option because it allows the holder to receive shares of A’s common stock upon exercise at a fixed conversion rate.
-
-
The liquidation redemption option — This gives the holder the right to receive an amount equal to the original issuance price, plus dividends. The option should be evaluated as a redemption feature because it entitles the holder to receive a fixed amount of cash in exchange for the shares.
-
The default dividends — This feature would be evaluated separately in a manner similar to incremental interest incurred in an event of default. Since the default dividends are payable separately from any of the conversion or redemption options, this feature should be evaluated as a separate embedded feature rather than an adjustment to the payoff in other settlement scenarios.
4.3 Bifurcation Criteria
4.3.1 Overall Framework
ASC 815-15
25-1
An embedded derivative shall be separated from the host
contract and accounted for as a derivative instrument
pursuant to Subtopic 815-10 if and only if all of the
following criteria are met:
-
The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
-
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
-
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
Once an entity has identified the embedded features that require
evaluation, it should determine whether those features must be accounted for
separately as a derivative. Under ASC 815-15-25-1, an entity is required to
separately account for a feature embedded within another contract (the host
contract) if all of the following three conditions are met:
-
The embedded feature and the host contract have economic characteristics and risks that are not clearly and closely related (see Section 4.3.2). For example, changes in the fair value of an equity interest — such as an equity conversion feature — are not clearly and closely related to the interest rates on a debt host contract (see Section 6.2.2.2).
-
The hybrid instrument (i.e., the combination of the embedded feature and its host contract) is not remeasured at fair value, with changes in fair value recorded through earnings (e.g., an investment in an equity security subject to ASC 321, an instrument accounted for under the fair value option in ASC 815-15 or ASC 825-10; see Section 4.3.3).
-
The embedded feature — if issued separately — would be accounted for as a derivative instrument under ASC 815-10. In evaluating whether this condition is met, the entity considers both (1) the definition of a derivative in ASC 815-10 (see Section 4.3.4) and (2) the scope exceptions from derivative accounting in ASC 815-10 and ASC 815-15 (see Sections 2.3 and 4.3.5).
There is no requirement to evaluate the bifurcation conditions in any particular
order. Because all three conditions must be met, the analysis ends if any one
condition is not satisfied. For example:
-
If the hybrid instrument is accounted for at fair value, with changes in fair value recognized in earnings, the entity does not need to identify potential embedded derivatives and can omit an evaluation of whether any embedded features (1) are clearly and closely related to the host contract or (2) would have been accounted for as derivatives if they were freestanding contracts.
-
If an embedded feature is clearly and closely related to its host contract, an evaluation of whether it meets the definition of a derivative is not required.
-
If an embedded feature does not meet the definition of a derivative (e.g., it does not satisfy the net settlement characteristic in the definition of a derivative), it is unnecessary to evaluate whether it (1) is subject to any scope exception related to derivative accounting or (2) is clearly and closely related to its host contract, because in either case, the feature would not be bifurcated as a derivative.
-
If the feature is subject to a derivative scope exception, the entity can omit an evaluation of whether the feature is clearly and closely related to its host contract since bifurcation as a derivative is prohibited.
In lieu of bifurcating an identified embedded derivative, an
entity may elect to account for the entire hybrid instrument at fair value under
ASC 815-15-25-4 provided that the instrument is a financial asset or financial
liability, with changes recognized in earnings and, if applicable, other
comprehensive income (OCI) (see Chapter 12 of Deloitte’s Roadmap Fair Value Measurements and
Disclosures (Including the Fair Value Option) for further
detail).
4.3.2 Condition 1 — Not Clearly and Closely Related
4.3.2.1 Background
ASC 815-15
25-1 An embedded
derivative shall be separated from the host contract
and accounted for as a derivative instrument
pursuant to Subtopic 815-10 if and only if all of
the following criteria are met:
-
The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract. . . .
The first bifurcation condition in ASC 815-15-25-1 is that the embedded
feature and the host contract have economic characteristics and risks that
are not clearly and closely related to each other. In evaluating whether
this condition is met, the entity must determine the nature of the host
contract and identify the economic characteristics and risks of the embedded
feature. The evaluation of the clearly-and-closely-related criterion will
depend on the nature of the host contract, which is most often a debt,
equity, or lease host, but could also be a supply contract or insurance
agreement. Chapter 5 focuses on evaluating common
embedded features that are unique to a debt host contract, while
Chapter 6 includes evaluation of embedded features
that are commonly present in all host contracts. The discussion below
describes the framework for evaluating Condition 1.
4.3.2.2 Hybrid Contracts in the Legal Form of Debt
If the hybrid instrument is in the legal form of debt (i.e., the holder has
creditor rights), the host contract is considered to have the economic
characteristics and risks of a debt instrument.
Although a hybrid instrument may include embedded features that have the
economic characteristics and risks of an equity instrument (e.g., a dividend
participation right or a payment feature based on the entity’s stock price),
the host contract would nevertheless be considered a debt instrument if the
legal form of the hybrid instrument is debt.
For hybrid instruments with debt host contracts, the entity
must identify the terms of such debt host contract on the basis of the
stated or implied substantive terms of the hybrid instrument (e.g., a fixed
rate, a variable rate, or a zero coupon; see Section 4.3.2.5). An entity is not permitted to impute terms
in the debt host contract that would result in the identification of an
embedded derivative that is not clearly present in the hybrid
instrument.
4.3.2.3 Hybrid Contracts in the Legal Form of an Outstanding Share
4.3.2.3.1 Overview
ASC 815-15
25-16 If the host contract
encompasses a residual interest in an entity, then
its economic characteristics and risks shall be
considered that of an equity instrument and an
embedded derivative would need to possess
principally equity characteristics (related to the
same entity) to be considered clearly and closely
related to the host contract.
25-17 Because the changes
in fair value of an equity interest and interest
rates on a debt instrument are not clearly and
closely related, the terms of convertible
preferred stock shall be analyzed to determine
whether the preferred stock (and thus the
potential host contract) is more akin to an equity
instrument or a debt instrument.
25-17A For a hybrid
financial instrument issued in the form of a
share, an entity shall determine the nature of the
host contract by considering all stated and
implied substantive terms and features of the
hybrid financial instrument, weighing each term
and feature on the basis of the relevant facts and
circumstances. That is, in determining the nature
of the host contract, an entity shall consider the
economic characteristics and risks of the entire
hybrid financial instrument including the embedded
derivative feature that is being evaluated for
potential bifurcation. In evaluating the stated
and implied substantive terms and features, the
existence or omission of any single term or
feature does not necessarily determine the
economic characteristics and risks of the host
contract. Although an individual term or feature
may weigh more heavily in the evaluation on the
basis of the facts and circumstances, an entity
should use judgment based on an evaluation of all
of the relevant terms and features. For example,
an entity shall not presume that the presence of a
fixed-price, noncontingent redemption option held
by the investor in a convertible preferred stock
contract, in and of itself, determines whether the
nature of the host contract is more akin to a debt
instrument or more akin to an equity instrument.
Rather, the nature of the host contract depends on
the economic characteristics and risks of the
entire hybrid financial instrument.
25-17B The guidance in
paragraph 815-15-25-17A relates to determining
whether a host contract within a hybrid financial
instrument issued in the form of a share is
considered to be more akin to a debt instrument or
more akin to an equity instrument for the purposes
of evaluating one or more embedded derivative
features for bifurcation under paragraph
815-15-25-1(a). It is not intended to address when
an embedded derivative feature should be
bifurcated from the host contract or the
accounting when such bifurcation is required. In
addition, the guidance in paragraph 815-15-25-17A
is not intended to prescribe the method to be used
in determining the nature of the host contract in
a hybrid financial instrument that is not issued
in the form of a share.
If the host contract is in the legal form of a share (e.g., preferred
stock), the evaluation of whether the contract should be considered a
debt host or an equity host is not based solely on its legal form or
whether it qualifies for presentation as equity (including temporary
equity) under GAAP. Instead, an entity is required to use a
“whole-instrument approach” under which it determines the nature of the
host contract by considering all of its stated or implied substantive
terms and features. Accordingly, an entity must further analyze the
economic characteristics and risks of the hybrid contract to determine
whether the contract should be considered a debt host or an equity host.
For example, an outstanding share that is classified as a liability
under ASC 480 or as temporary equity under ASC 480-10-S99-3A could
potentially qualify as a debt host contract depending on its terms and
conditions. An entity is not permitted to use (1) a “chameleon approach”
under which the nature of the host contract is determined on the basis
of an analysis that excludes the embedded feature that is evaluated for
bifurcation or (2) a “pure host” approach under which the nature of the
host contract is determined by excluding all potential embedded
derivative features.
An entity must identify the nature of the host contract as of the hybrid
instrument’s initial recognition date (i.e., upon its issuance or
acquisition). The entity is required to reassess that determination upon
a modification or exchange of the hybrid instrument that is accounted
for as an extinguishment. The determination of whether a reassessment is
required for a modification or exchange that is not accounted for as an
extinguishment depends on the relevant facts and circumstances.
Liability-classified outstanding shares will generally contain debt host
contracts. However, it is possible for such a share to contain an equity
host contract. Furthermore, some equity-classified hybrid instruments
will contain debt hosts (in which case the evaluation of embedded
derivatives is the same as that for a hybrid instrument that is in the
legal form of debt). The sections below discuss the guidance on
determining the nature of the host contract for a hybrid instrument in
the form of a share.
4.3.2.3.2 Framework for Determining Whether an Outstanding Share Is a Debt Host or an Equity Host
ASC 815-15
25-17C When applying the
guidance in paragraph 815-15-25-17A, an entity
shall determine the nature of the host contract by
considering all stated and implied substantive
terms and features of the hybrid financial
instrument, determining whether those terms and
features are debt-like versus equity-like, and
weighing those terms and features on the basis of
the relevant facts and circumstances. That is, an
entity shall consider not only whether the
relevant terms and features are debt-like versus
equity-like, but also the substance of those terms
and features (that is, the relative strength of
the debt-like or equity-like terms and features
given the facts and circumstances). In assessing
the substance of the relevant terms and features,
each of the following may form part of the overall
analysis and may inform an entity’s overall
consideration of the relative importance (and,
therefore, weight) of each term and feature among
other terms and features:
-
The characteristics of the relevant terms and features themselves (for example, contingent versus noncontingent, in-the-money versus out-of-the-money)
-
The circumstances under which the hybrid financial instrument was issued or acquired (for example, issuer-specific characteristics, such as whether the issuer is thinly capitalized or profitable and well- capitalized)
-
The potential outcomes of the hybrid financial instrument (for example, the instrument may be settled by the issuer issuing a fixed number of shares, the instrument may be settled by the issuer transferring a specified amount of cash, or the instrument may remain legal-form equity), as well as the likelihood of those potential outcomes. The assessment of the potential outcomes may be qualitative in nature.
25-17D The following are
examples (and not an exhaustive list) of common
terms and features included within a hybrid
financial instrument issued in the form of a share
and the types of information and indicators that
an entity (an issuer or an investor) may consider
when assessing the substance of those terms and
features in the context of determining the nature
of the host contract, as discussed in paragraph
815-15-25-17C:
-
Redemption rights. The ability for an issuer or investor to redeem a hybrid financial instrument issued in the form of a share at a fixed or determinable price generally is viewed as a debt-like characteristic. However, not all redemption rights are of equal importance. For example, a noncontingent redemption option may be given more weight in the analysis than a contingent redemption option. The relative importance (and, therefore, weight) of redemption rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
-
Whether the redemption right is held by the issuer or investors
-
Whether the redemption is mandatory
-
Whether the redemption right is noncontingent or contingent
-
Whether (and the degree to which) the redemption right is in-the-money or out-of-the-money
-
Whether there are any laws that would restrict the issuer or investors from exercising the redemption right (for example, if redemption would make the issuer insolvent)
-
Issuer-specific considerations (for example, whether the hybrid financial instrument is effectively the residual interest in the issuer [due to the issuer being thinly capitalized or the common equity of the issuer having already incurred losses] or whether the instrument was issued by a well-capitalized, profitable entity)
-
If the hybrid financial instrument also contains a conversion right, the extent to which the redemption price (formula) is more or less favorable than the conversion price (formula), that is, a consideration of the economics of the redemption price (formula) and the conversion price (formula), not simply the form of the settlement upon redemption or conversion.
-
-
Conversion rights. The ability for an investor to convert, for example, a preferred share into a fixed number of common shares generally is viewed as an equity-like characteristic. However, not all conversion rights are of equal importance. For example, a conversion option that is noncontingent or deeply in-the-money may be given more weight in the analysis than a conversion option that is contingent on a remote event or deeply out-of-the-money. The relative importance (and, therefore, weight) of conversion rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
-
Whether the conversion right is held by the issuer or investors
-
Whether the conversion is mandatory
-
Whether the conversion right is noncontingent or contingent
-
Whether (and the degree to which) the conversion right is in-the-money or out-of-the-money
-
If the hybrid financial instrument also contains a redemption right held by the investors, whether conversion is more likely to occur before redemption (for example, because of an expected initial public offering or change-in-control event before the redemption right becoming exercisable).
-
-
Voting rights. The ability for a class of stock to exercise voting rights generally is viewed as an equity-like characteristic. However, not all voting rights are of equal importance. For example, voting rights that allow a class of stock to vote on all significant matters may be given more weight in the analysis than voting rights that are only protective in nature. The relative importance (and, therefore, weight) of voting rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
-
On which matters the voting rights allow the investor’s class of stock to vote (relative to common stock shareholders)
-
How much influence the investor’s class of stock can exercise as a result of the voting rights.
-
-
Dividend rights. The nature of dividends can be viewed as a debt-like or equity-like characteristic. For example, mandatory fixed dividends generally are viewed as a debt-like characteristic, while discretionary dividends based on earnings generally are viewed as an equity-like characteristic. The relative importance (and, therefore, weight) of dividend terms among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
-
Whether the dividends are mandatory or discretionary
-
The basis on which dividends are determined and whether the dividends are stated or participating
-
Whether the dividends are cumulative or noncumulative.
-
-
Protective covenants. Protective covenants generally are viewed as a debt-like characteristic. However, not all protective covenants are of equal importance. Covenants that provide substantive protective rights may be given more weight than covenants that provide only limited protective rights. The relative importance (and, therefore, weight) of protective covenants among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
-
Whether there are any collateral requirements akin to collateralized debt
-
If the hybrid financial instrument contains a redemption option held by the investor, whether the issuer’s performance upon redemption is guaranteed by the parent of the issuer
-
Whether the instrument provides the investor with certain rights akin to creditor rights (for example, the right to force bankruptcy or a preference in liquidation).
-
To determine the nature of the host contract under the
whole-instrument approach, an entity performs the following steps:
-
Identify all of the hybrid financial instrument’s stated and implied substantive terms and features (see Section 4.3.2.3.3).
-
Determine whether each of the identified terms and features is more debt-like or equity-like (see Section 4.3.2.3.4).
-
Consider the relative weight of the identified terms and features “on the basis of the relevant facts and circumstances” (see Section 4.3.2.3.5).
-
Reach a conclusion about the nature of the host contract (see Section 4.3.2.3.6).
4.3.2.3.3 Step 1 — Identify the Hybrid Instrument’s Substantive Terms and Features
The first step in applying the whole-instrument approach is to identify
all of the substantive terms and features of the hybrid financial
instrument, whether stated or implied. ASC 815-15-25-17D lists common
terms and features in hybrid instruments that are in the form of
shares.
4.3.2.3.4 Step 2 — Determine Whether the Identified Terms and Features Are More Debt-Like or Equity-Like
The next step in applying the whole-instrument approach is to determine
whether the identified substantive terms and features of the hybrid
instrument are more debt- or equity-like. To make this determination, an
entity should analyze the terms’ or features’ economic characteristics
and risks.
ASC 815-15-25-16 explains that a host contract is considered equity-like
if it “encompasses a residual interest in an entity.” By contrast, a
term or feature that is not consistent with a residual interest in the
issuing entity would most likely be considered debt-like. ASC
815-15-25-17D provides examples of common terms and features, discusses
whether such terms and features are generally debt- or equity- like, and
lists factors that an entity might consider in determining the relative
weight to assign to such terms and features.
The following chart
illustrates which characteristics are generally more debt-like or
equity-like:
*
Instrument may be settled by the issuer’s transfer of a
specified amount of cash or a variable number of shares
equal to a fixed dollar amount.
4.3.2.3.5 Step 3 — Weigh the Identified Terms and Features
The third step is to weigh each of the hybrid financial
instrument’s substantive terms and features — qualitatively,
quantitatively, or both — “on the basis of the relevant facts and
circumstances,” as described in ASC 815-15-25-17C. The entity determines
the “relative strength” or weight of each of the hybrid financial
instrument’s substantive terms and features by considering the following:
-
The characteristics of the relevant terms and features themselves — For example, for a redemption option, the entity should consider whether the option is (1) mandatory or optional and (2) contingent or noncontingent. A mandatory redemption right would be given more weight than an optional redemption right, and a noncontingent redemption right would be given more weight than a contingent redemption right. ASC 815-15-25-17D provides a list of characteristics that a reporting entity should consider in its analysis. Although not an all-inclusive list, these characteristics are discussed further in the table below.
-
The circumstances under which the hybrid financial instrument was issued or acquired — This condition is generally meant to help an entity assess whether the hybrid financial instrument is, in substance, a residual interest in the issuing entity. For example, a hybrid financial instrument issued by a thinly capitalized entity (or one with an accumulated deficit) might be considered more equity-like than a hybrid financial instrument issued by a well-capitalized profitable entity. This is because in a thinly capitalized entity, the hybrid financial instrument may, in substance, represent a residual interest in that issuing entity even if other classes of equity are more subordinated.
-
The potential outcomes of the hybrid financial instrument as well as the likelihood of those potential outcomes — This condition is meant to help an entity assess the hybrid financial instrument’s likely economic return. For example, a hybrid financial instrument that is expected to be settled in a fixed number of common shares (thus providing a more equity-like return) might be viewed as more equity-like than a hybrid financial instrument that is expected to be settled in a specified amount of cash or a variable number of shares that is equal to a fixed dollar amount (thus providing a more debt-like return).
The table below provides examples of indicators that a reporting entity
should consider in determining whether to assign more or less weight to
the general view related to whether a term or feature is debt-like or
equity-like in the entity’s analysis of the nature of the host contract
for a hybrid instrument issued in the form of a share. This table does
not apply to hybrid instruments issued in the form of debt.
General View
|
Indicators That the General View
Should Be Given More Weight
|
Indicators That the General View
Should Be Given Less Weight
|
---|---|---|
Redemption rights are debt-like
|
|
|
Conversion rights are an equity-like term or
feature
|
|
|
Voting rights are an equity-like term or
feature
|
|
|
Protective covenants are a debt-like term or
feature
|
|
|
Dividends are either a debt-like or an
equity-like feature
|
Dividend rights that are mandatory, stated, or
cumulative add weight to the view that a debt host
is more debt-like. Dividend rights that are
discretionary, participating, or noncumulative add
weight to the view that a debt host is more
equity-like.
|
4.3.2.3.6 Step 4 — Reach a Conclusion About the Nature of the Host Contract
The final step is to reach a conclusion regarding the nature of the host
contract on the basis of the results of the analyses performed in the
previous steps. As explained in ASC 815-15-25-17A, “[i]n evaluating the
stated and implied substantive terms and features, the existence or
omission of any single term or feature does not necessarily determine
the economic characteristics and risks of the host contract. Although an
individual term or feature may weigh more heavily in the evaluation on
the basis of the facts and circumstances, an entity should use judgment
based on an evaluation of all of the relevant terms and features.” To
further emphasize this point, ASC 815-15-25-17A states by way of example
that “an entity shall not presume that the presence of a fixed-price,
noncontingent redemption option held by the investor in a convertible
preferred stock contract, in and of itself, determines whether the
nature of the host contract is more akin to a debt instrument or more
akin to an equity instrument.” If the nature of the host contract is
still not clear, the entity should consider the expected outcome of the
hybrid financial instrument in reaching a conclusion. Given the
complexity of determining the nature of a host contract of a hybrid
instrument with both conversion and redemption features, entities are
encouraged to consult with their accounting advisers.
4.3.2.4 Other Host Contract Types
The following sections discuss host contracts other than those in the form of
a share or a debt instrument, including types of embedded features that are
often identified in such hosts.
4.3.2.4.1 Lease Hosts
ASC 815-15
25-21 Rentals for the use of
leased assets and adjustments for inflation on
similar property are considered to be clearly and
closely related. Thus, unless a significant
leverage factor is involved, the inflation-related
derivative instrument embedded in an
inflation-indexed lease would not be separated
from the host contract.
25-22 The obligation to make
future payments for the use of leased assets and
the adjustment of those payments to reflect
changes in a variable-interest-rate index are
considered to be clearly and closely related.
Thus, leases that include variable lease payments
based on changes in the prime rate would not have
the embedded derivative that is related to the
variable lease payment separated from the host
contract.
A lease host contract conveys the right to use property, plant, or
equipment in exchange for consideration during what is typically a
stated period. If a feature embedded in a lease host contract modifies
future cash flows under the contract, an entity is required to evaluate
the feature as a possible embedded derivative. Whether the lease takes
the form of an operating lease or a finance lease, as applicable under
ASC 842, has no impact on the determination of the nature of a host
contract. If the contract meets the definition of a lease under ASC
842-10-15-3, the contract is considered to contain a lease host in the
evaluation of the contract for embedded derivatives. However, a contract
that does not meet the definition of a lease under ASC 842-10-15-3 may
also contain a lease host. An entity should consult with its accounting
advisers regarding the determination of the nature of the host contract
to ensure that the facts and circumstances are appropriately weighed.
The guidance on accounting for lease host contracts in ASC 815-15 is
relatively brief in comparison to the detailed considerations provided
for debt and equity host contracts. In practice, embedded derivatives in
a lease host often qualify for the scope exception in ASC 815-10-15-59
(see Section 2.3.5.3) for contracts not traded on
an exchange whose settlement is based on sales volume or revenue. This
scope exception substantially reduces the number of possible features
that could require bifurcation from a lease host.
A feature that gives the lessee an option to purchase the leased asset at
the end of the lease term or provides a guarantee of the residual value
of the leased asset would be another common example of a lease-specific
feature that qualifies for a derivative scope exception and,
accordingly, would not require bifurcation from a lease host contract.
The scope exception in ASC 815-10-15-59(b)(2) indicates that if
settlement is based on the value of a nonfinancial asset of one of the
parties (i.e., the value of the leased asset), the feature would not be
accounted for as a derivative. This scope exception further reduces the
number of possible features that could require bifurcation from a lease
host.
Separately, some of the more common features embedded in a lease host
agreement are term extension features that give the lessee the option to
extend the lease at the end of the stated term. Term extension features
do not meet the definition of a derivative under ASC 815-10-15-83
because they do not meet the net settlement criterion and therefore
would not require bifurcation under ASC 815-15-25-1.
Complexity associated with the identification of an embedded derivative
in a lease host is generally related to whether the embedded feature is
clearly and closely related to the lease host. ASC 815-15-25-21
specifically notes that adjustments for inflation are clearly and
closely related to a lease host unless (1) a significant leverage factor
is involved or (2) the inflation metric used to adjust payments is
unrelated to the location of the asset. ASC 815-15-25-22 further
indicates that variable lease payments based on changes in interest
rates do not contain embedded derivatives that require bifurcation.
Example 4-6
Lease Contract With Adjustments That Are Based
on Interest Rate Changes
Company D has 10-year operating leases for retail
stores and a distribution center. The operating
lease payments are part of a synthetic lease
transaction in which an off-balance-sheet
special-purpose entity (SPE) has obtained debt
financing and equity that it will use to construct
the retail stores and distribution center. The SPE
will lease these buildings to D. The leases
require D to make quarterly variable lease
payments on the basis of the SOFR interest rate
and all financing by the SPE. If the SPE has drawn
cash to begin construction on one of the new
retail stores, D must begin to make interest
payments to the SPE on that drawn amount.
The operating leases for the
retail stores and distribution center have
embedded derivatives that result in adjustments to
the lease payment that are based on interest rates
(e.g., SOFR). The embedded derivative does not
need to be bifurcated because the obligation to
make future payments for the use of the leased
assets and the adjustment of those payments for
changes in a variable interest rate index are
considered clearly and closely related to the host
contracts under ASC 815-15-25-22. (Note that SPEs
should be evaluated to determine whether they are
subject to ASC 810-10. Some “synthetic lease”
transactions may be required to be consolidated
under ASC 810-10.)
Example 4-7
Lease
Contract With Embedded Inflation Index Feature
A U.S. company leases property,
and the lease payments require an adjustment that
is based on two times the change in the CPI. This
embedded derivative is not clearly and closely
related to the lease host because it is leveraged;
therefore, it should be accounted for separately.
Alternatively, if the lease payments were only
adjusted for changes in CPI with no leveraging,
the embedded derivative would be clearly and
closely related and, therefore, would not need to
be accounted for separately.
Lease host contracts may contain unique embedded features beyond those
discussed in this Roadmap, so entities should discuss any such features
with their accounting advisers. For further details on embedded features
that could be identified in a lease host, see Chapter
6.
4.3.2.4.2 Insurance Hosts
An insurance contract is another host contract type that could contain an
embedded derivative. In a manner similar to lease host contracts,
embedded features in insurance host contracts often meet specific
insurance-related scope exceptions (see Section
2.3.3).
In the event that an embedded feature in an insurance contract does not
qualify for a scope exception, the determinative step in the evaluation
of whether the embedded feature requires bifurcation often focuses on
the clearly-and-closely-related criterion. Some of the more common
features that could be present in an insurance contract include
equity-indexed annuities, equity-linked cash surrender values, and
foreign-currency options — none of which would be clearly and closely
related to an insurance host. Equity-indexed annuities and equity-linked
cash surrender values would not be considered clearly and closely
related to the insurance host because their values are derived from an
equity-related index, whose risks and rewards are presumably distinct
from those of an insurance host contract. The evaluation of features
involving certain currencies is more complex and is discussed in further
detail in Section 4.3.5.5.
Given the industry-specific nuances associated with insurance contracts,
entities should work with their accounting advisers to evaluate such
provisions.
Connecting the Dots
ASU 2018-12 amended
the accounting model for certain universal life-type contracts
and contracts that contain features that could provide
nontraditional contract benefits beyond those provided by the
insured’s account balance. An insurer that writes such contracts
should first assess whether those features meet the definition
of market risk benefits under ASC 944-40-25-25C and ASC
944-40-25-25D. If the features do not meet the definition of
market risk benefits, the insurer should assess whether to
account for the features as embedded derivatives in accordance
with ASC 815.
4.3.2.4.3 Executory Contract Hosts
There are a variety of possible contract types that would have an
executory contract host. We commonly see executory contracts in the form
of commodity purchase and sale contracts, raw materials purchase and
sale contracts, and purchased power agreements.
Executory contracts often meet the definition of a derivative in their
entirety, and in such cases, an entity would not be required to
bifurcate any embedded derivatives. In addition, the NPNS scope
exception may be applied to an executory contract that would otherwise
require derivative accounting if the conditions outlined in ASC
815-15-15-25 are met (see Section 2.3.2). In the
event that the executory contract qualifies for the NPNS election, the
entity would not further evaluate the executory contract for potential
embedded derivatives.
If the contract as a whole does not meet the definition of a derivative
and the entity has not elected the NPNS scope exception, the entity
should apply the guidance in ASC 815-15-25-1 to determine whether any
embedded features require bifurcation.
Features embedded in executory host contracts commonly
include caps and floors based on the selling price of the asset that is
the subject of the purchase or sale contract. ASC 815-15-25-19 states
that the “economic characteristics and risks of a floor and cap on the
price of an asset embedded in a contract to purchase that asset are
clearly and closely related to the purchase contract, because the
options are indexed to the purchase price of the asset that is the
subject of the purchase contract.” Accordingly, such caps or floors
generally do not require bifurcation from the executory host
contract.
Executory payments that are indexed to inflation are clearly and closely
related to the host unless (1) a significant leverage factor is involved
or (2) the inflation index is unrelated to the economic environment of
the parties to the contract.
In addition, executory contracts could be payable in another currency,
which would be an embedded feature that the entity should evaluate for
possible bifurcation (see Section 4.3.5.5). Given
the variety of possible features embedded in this broader host contract
type, entities are encouraged to discuss the potential embedded
derivatives with their accounting advisers.
4.3.2.5 Host Contract Terms
ASC 815-15
25-24 The characteristics of
a debt host contract generally shall be based on the
stated or implied substantive terms of the hybrid
instrument. Those terms may include a fixed-rate,
variable-rate, zero-coupon, discount or premium, or
some combination thereof.
25-25 In the absence of
stated or implied terms, an entity may make its own
determination of whether to account for the debt
host as a fixed-rate, variable-rate, or zero-coupon
bond. That determination requires the application of
judgment, which is appropriate because the
circumstances surrounding each hybrid instrument
containing an embedded derivative may be different.
That is, in the absence of stated or implied terms,
it is appropriate to consider the features of the
hybrid instrument, the issuer, and the market in
which the instrument is issued, as well as other
factors, to determine the characteristics of the
debt host contract. However, an entity shall not
express the characteristics of the debt host
contract in a manner that would result in
identifying an embedded derivative that is not
already clearly present in a hybrid instrument. For
example, it would be inappropriate to do either of
the following:
-
Identify a variable-rate debt host contract and an interest rate swap component that has a comparable variable-rate leg in an embedded compound derivative, in lieu of identifying a fixed-rate debt host contract
-
Identify a fixed-rate debt host contract and a fixed-to-variable interest rate swap component in an embedded compound derivative in lieu of identifying a variable-rate debt host contract.
A contract in the legal form of debt is always considered a debt host
contract (see Section 4.3.2.2). If the contract is in
the legal form of an outstanding share, the entity must determine whether it
has the characteristics and risks of a debt host contract or an equity host
contract (see Section 4.3.2.3).
The terms of a debt host contract are identified on the basis of the terms of
the hybrid debt instrument. For example, a fixed-rate hybrid debt contract
would have a fixed-rate debt host contract, and a variable-rate hybrid debt
contract would have a variable-rate debt host contract. An entity is not
permitted to impute terms in the host contract that are not clearly present
in the hybrid instrument, such as artificial terms that “introduce leverage,
asymmetry, or some other risk exposure not already present in the hybrid
instrument” (see ASC 815-15-30). For example, a debtor cannot impute a
pay-fixed, receive-variable interest rate swap and identify the debt host
contract as variable-rate debt if the hybrid debt instrument makes fixed
interest payments.
4.3.2.6 Determining Whether an Embedded Feature Is Clearly and Closely Related to Its Host Contract
ASC 815 contains extensive application guidance on
evaluating whether particular types of embedded features should be
considered clearly and closely related to their host contracts. An embedded
feature needs to possess principally debt-like characteristics to be
considered clearly and closely related to a debt host contract. Contractual
terms could potentially qualify as a debt-like feature if they are based on
market interest rates, the issuer’s credit risk, or inflation. However, an
entity cannot assume that a feature that is based on one of those
underlyings is clearly and closely related to a debt host contract without
further analysis under the detailed provisions in ASC 815-15 (e.g., the
negative-yield test and the double-double test for underlyings based on
interest rates; see Section 5.2.3). To
be considered clearly and closely related to an equity host contract, a
feature embedded in the host should be related to the equity of the issuer.
The following table highlights some of the economic characteristics that are
and are not generally considered to be clearly and closely related to debt,
equity, lease, insurance, and purchase- or sale-related host contracts.
Clearly and Closely Related
|
Not Clearly and Closely Related
| |
---|---|---|
Debt host
|
|
|
Equity host
|
|
|
Lease host
|
|
|
Insurance host
|
|
|
Purchase/sales host
|
|
|
The evaluation of whether an embedded feature is clearly and closely related
to its host contract is assessed at the inception of the contract and is not
revisited unless the contract is modified.
See Chapters 5 and 6 for further
discussion of the application of the embedded derivatives guidance to
specific features and instruments, including how to evaluate whether
features are clearly and closely related to the host contract in commonly
observed scenarios.
4.3.3 Condition 2 — Hybrid-Instrument Accounting
ASC 815-15
25-1
An embedded derivative shall be separated from the host
contract and accounted for as a derivative instrument
pursuant to Subtopic 815-10 if and only if all of the
following criteria are met: . . .
b. The hybrid instrument is not remeasured at
fair value under otherwise applicable generally
accepted accounting principles (GAAP) with changes
in fair value reported in earnings as they occur.
. . .
The second bifurcation condition in ASC 815-15-25-1 is that the hybrid instrument
is not remeasured at fair value, with changes in fair value recognized in
earnings. If an entity has applied the fair value option in ASC 815-15 or ASC
825-10 to a hybrid debt instrument, an embedded feature would not be bifurcated.
This bifurcation condition would not be met for a financial liability for which
the fair value has been elected even though changes in fair value attributable
to instrument-specific credit risk are recognized in OCI under ASC
825-10-45-5.
ASC 825 prohibits an entity from electing the fair value option
for a financial instrument that would be classified, in whole or in part, as
equity. Because ASC 470-20 requires a convertible debt instrument issued at a
substantial premium to be presented, in part, in equity (see Section 7.6 of
Deloitte’s Roadmap Issuer’s Accounting for Debt), the issuer cannot
elect the fair value option for it. Similarly, instruments classified in
permanent equity and outside of permanent equity in accordance with ASC
480-10-S99-3A would be precluded from the fair value option as equity-classified
instruments.
If a liability is measured at (1) intrinsic value under the
indexed-debt guidance in ASC 470-10 or (2) settlement value in accordance with
ASC 480-10-35-3 (see Sections 4.3.1.2 and 5.3.1.1 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity), an entity should not consider the liability to
be accounted for at fair value when assessing whether an embedded feature must
be bifurcated. Although the intrinsic value or settlement value might
approximate fair value, it does not take into account all of an instrument’s
attributes that are included in a fair value estimate — for example, the time
value of an option. Thus, an instrument that is remeasured at intrinsic value or
settlement value may contain an embedded feature that must be bifurcated.
Under ASC 321, investments in equity securities are considered instruments that
are remeasured at fair value, with changes in fair value reported in earnings
even if they are accounted for by using the measurement alternative described in
ASC 321-10-35-2. Investments in debt securities classified as trading securities
would not meet the condition in ASC 815-15-25-1(b); however, investments in debt
securities classified as HTM or AFS would meet such condition.
4.3.3.1 Fair Value Versus Settlement Value
Although ASC 815-10-30-1 and ASC 480-10-30-1 through 30-3 require initial
measurement at fair value, many instruments accounted for as liabilities
under ASC 480-10-25 subsequently are adjusted to their “settlement value,”
as detailed in ASC 480-10-35-3. Although it is possible for the settlement
value to approximate fair value, certain attributes of an instrument
included in an estimate of fair value are not contemplated in the
calculation of its settlement value — for example, an option’s time value.
Thus, an instrument that is remeasured at settlement value under ASC
480-10-35-3 would meet the condition in ASC 815-15-25-1(b) since it is not
remeasured at fair value.
Example 4-8
Fair Value Versus Settlement Value
Company A issues 100,000 shares of mandatorily
redeemable preferred stock for proceeds of $1
million. These shares must be redeemed in five years
for an amount equal to the greater of (1) the
initial $1 million investment or (2) an amount
indexed to changes in the price of gold.
The preferred shares are classified as a liability in
accordance with ASC 480-10-25 because of the
mandatory redemption and will be measured
subsequently at their settlement value because the
amount to be paid upon settlement is not fixed. When
analyzing ASC 815-15-25-1 to determine whether the
redemption indexed to changes in the price of gold
must be separated from the host contract and
accounted for as a derivative, an entity should
consider the condition in ASC 815-15-25-1(b) to be
met because the shares are recorded at their
redemption value rather than fair value. In this
case, the conditions in ASC 815-15-25-1(a) and ASC
815-15-25-1(c) also are met. Therefore, the “gold
index feature” of the preferred shares should be
accounted for separately as a derivative unless A
has (1) made the election in ASC 815-15-25-4 or (2)
elected the fair value option in ASC 825-10 to
measure the entire hybrid financial instrument at
fair value, with changes in fair value recognized in
earnings.
4.3.3.2 Fair Value Versus Redemption Value
Irrespective of whether a hybrid instrument requires
presentation outside of permanent equity in accordance with ASC
480-10-S99-3A, the issuer must evaluate whether any embedded features exist
that require bifurcation under ASC 815-15-25-1. If embedded derivatives
requiring bifurcation are identified in a temporary equity classified
instrument, the initial amount presented in temporary equity is the amount
attributable to the hybrid instrument that remains after separation of the
embedded derivative in accordance with ASC 815-15-30-2.
Even if a temporary-equity classified instrument is subject to the subsequent
measurement adjustments in accordance with the SEC’s guidance, such
instrument would meet the criteria in ASC 815-15-25-1(b); that is, it would
not be subject to recurring fair value measurements. The subsequent
measurement model for temporary-equity classified instruments requires
entities to reflect certain instruments at their redemption value, which
differs from their fair value.1
4.3.4 Condition 3 — Derivative Instrument
ASC 815-15
25-1 An embedded derivative
shall be separated from the host contract and accounted
for as a derivative instrument pursuant to Subtopic
815-10 if and only if all of the following criteria are
met: . . .
c. A separate instrument with the same terms as
the embedded derivative would, pursuant to Section
815-10-15, be a derivative instrument subject to
the requirements of Subtopic 815-10 and this
Subtopic. (The initial net investment for the
hybrid instrument shall not be considered to be
the initial net investment for the embedded
derivative.)
The third bifurcation condition in ASC 815-15-25-1 is that the embedded feature
would have been accounted for as a derivative instrument under ASC 815 if it
were a separate freestanding instrument. To determine whether this condition has
been satisfied, the entity evaluates whether the feature (1) would have met the
definition of a derivative instrument in ASC 815-10 on a stand-alone basis and
(2) meets any of the scope exceptions in ASC 815-10 and ASC 815-15. An embedded
feature would not be bifurcated if it does not meet the definition of a
derivative instrument on a freestanding basis or it qualifies for a scope
exception.
The initial investment in a hybrid instrument is not considered the initial net
investment for an embedded feature in that instrument (as noted in ASC
815-15-25-1). Instead, the initial net investment in the embedded feature is the
amount an entity would have been required to invest in a freestanding contract
with terms that are similar to those of the embedded feature, excluding the host
contract of the hybrid instrument. That is, the initial investment needed to
acquire or incur the host contract (e.g., the fair value of a debt host
contract) does not form part of the initial investment of any embedded feature
in the same hybrid instrument. Therefore, the initial net investment
characteristic typically is met for embedded features in debt host
contracts.
Example 4-9
Initial Net Investment in Conversion Option Embedded
in a Debt Instrument
The initial net investment in a conversion option
embedded in a debt instrument is the option’s fair
value; it is not the fair value of the convertible debt
or the fair value of the shares that would be delivered
upon exercise of the conversion feature. When evaluating
whether the initial net investment characteristic is
met, an entity compares the fair value of the conversion
option on the date of the debt’s issuance with the fair
value of the underlying shares that are deliverable to
the holders upon exercise of the conversion option. If
the fair value of the conversion option is less, by more
than a nominal amount, than the fair value of the
instrument into which the option is convertible on the
date of issuance, the initial net investment
characteristic is met.
As discussed in Section 1.4.3, one of the conditions for
meeting the definition of a derivative in ASC 815-10-15-83 is that a contract
must be net settleable, which can be achieved in any one of the following ways:
(1) it can be settled net via the contract terms, (2) a market mechanism exists
that facilitates net settlement, or (3) the asset is RCC. When applying these
criteria to an embedded feature, an entity would consider the following:
-
Contractual net settlement — Under ASC 815-10-15-100, net settlement may be made in cash or by delivery of any other asset, and there cannot be a requirement for either party to deliver an asset that is associated with the underlying. For example, if a preferred stock contract with an equity host has an embedded conversion feature that contractually requires physical settlement in shares, the embedded feature would not meet the contractual net settlement criterion because shares must be delivered to the counterparty.
-
Market mechanism — This criterion is not applied to embedded features because they are not freestanding financial instruments that can be separately transferrable from the host contract.
-
RCC — Under ASC 815-10-15-119, if the asset to be delivered is RCC, the embedded feature requiring such delivery would meet the net settlement condition. For example, a preferred stock contract with an equity host that has an embedded conversion feature requiring physical settlement in shares could still meet the net settlement condition if the entity’s shares were publicly traded (and therefore considered RCC). Note that the application of this condition to conversion features often depends upon whether the entity is privately or publicly held.
Chapters 5 and 6 include further
guidance on the application of the net settlement criterion to specific host
contract types.
4.3.5 Scope Exceptions for Embedded Derivative Evaluation
ASC 815-15
15-3
The guidance in this Subtopic does not apply to any of
the following items, as discussed further in this
Section:
-
Normal purchases and normal sales contracts
-
Unsettled foreign currency transactions
-
Plain-vanilla servicing rights
-
Features involving certain aspects of credit risk
-
Features involving certain currencies.
An embedded derivative that meets a derivative accounting scope
exception in ASC 815-10-15-13 or ASC 815-15-15-3 should not be bifurcated from
its host contract. As described in Chapter 2, a contract that qualifies for a
derivative scope exception in accordance with ASC 815-10-15-13 may still contain
an embedded feature that requires bifurcation in accordance with ASC
815-15-25-1. In such case, the embedded feature would be bifurcated and recorded
as a derivative, and the remaining host contract would be eligible for a scope
exception and accounted for under applicable GAAP for that contract. See
Chapter 2 for
further discussion of the derivative scope exceptions in ASC 815-10.
The sections below detail the scope exceptions in ASC
815-15-15-3. These are incremental scope exceptions that only apply to embedded
derivative analysis.
4.3.5.1 Normal Purchases and Normal Sales
ASC 815-15
15-4 A contract that meets
the definition of a derivative instrument in its
entirety but qualifies for the normal purchases and
normal sales scope exception as discussed beginning
in paragraph 815-10-15-22 shall not also be assessed
under paragraph 815-15-25-1
The scope exception in ASC 815-15-15-4 refers to the NPNS scope exception in
ASC 815-10 (see Section 2.3.2 for further discussion of
the NPNS scope exception). The embedded derivative guidance in ASC 815-15
does not apply to a contract that qualifies for the NPNS scope exception
because the existence of an embedded feature that is not clearly and closely
related to the contract would disqualify the contract from being an NPNS
contract.
4.3.5.2 Unsettled Foreign Currency Transactions
ASC 815-15
15-5 Unsettled foreign
currency transactions, including financial
instruments, shall not be considered to contain
embedded foreign currency derivatives under this
Subtopic if the transactions meet all of the
following criteria:
-
They are monetary items.
-
They have their principal payments, interest payments, or both denominated in a foreign currency.
-
They are subject to the requirement in Subtopic 830-20 to recognize any foreign currency transaction gain or loss in earnings.
15-6 The proscription in
paragraph 815-15-15-5 applies to available-for-sale
or trading debt securities that have cash flows
denominated in a foreign currency.
Case R: Short-Term Loan With a Foreign Currency
Option
55-211 A U.S. lender
issues a loan at an above-market interest rate. The
loan is made in U.S. dollars, the borrower’s
functional currency, and the borrower has the option
to repay the loan in U.S. dollars or in a fixed
amount of a specified foreign currency.
55-212 This instrument can be
viewed as combining a loan at prevailing market
interest rates and a foreign currency option. The
lender has written a foreign currency option
exposing it to changes in foreign currency exchange
rates during the outstanding period of the loan. The
premium for the option has been paid as part of the
interest rate. Because the borrower has the option
to repay the loan in U.S. dollars or in a fixed
amount of a specified foreign currency, the
provisions of paragraph 815-15-15-5 are not relevant
to this Case. That paragraph addresses
foreign-currency-denominated interest or principal
payments but does not apply to foreign currency
options embedded in a
functional-currency-denominated debt host contract.
Because a foreign currency option is not clearly and
closely related to issuing a loan, the embedded
option should be separated from the host contract
and accounted for by both parties pursuant to the
provisions of this Subtopic. In contrast, if both
the principal payment and the interest payments on
the loan had been payable only in a fixed amount of
a specified foreign currency, there would be no
embedded foreign currency derivative pursuant to
this Subtopic.
Under ASC 815-15-15-5, debt with principal or interest payments (or both)
that are denominated in a foreign currency is deemed not to contain an
embedded foreign currency derivative if the amounts that are denominated in
a foreign currency must be remeasured at spot rates under ASC 830-20. If the
interest payments of a dual-currency bond whose principal is denominated in
dollars are denominated in a different currency, for example, ASC
815-15-55-210 requires the interest payments to be accounted for by
discounting “the future equivalent dollar interest payments determined by
the current spot exchange rate” at the debt’s original effective interest
rate. Under the interest method, the principal payment would also be
discounted by using the debt’s original effective interest rate.
The exemption in ASC 815-15-15-5 does not apply to a foreign currency feature
that is not required to be remeasured under ASC 830-20 for changes in spot
foreign currency exchange rates. For example, the exemption does not apply
to an option to pay principal or interest payments in one or more
alternative currencies other than the debt’s currency of denomination unless
the amount owed in the alternative currency is determined by applying the
current spot exchange rate at the time of payment to the amount owed in the
debt’s currency of denomination.
4.3.5.3 Plain-Vanilla Servicing Rights
ASC 815-15
15-7 Plain-vanilla
servicing rights, which involve an obligation to
perform servicing and the right to receive fees for
performing that servicing, do not contain an
embedded derivative that would be separated from
those servicing rights and accounted for as a
derivative instrument.
Under ASC 815-15-15-7, plain-vanilla servicing rights do not contain embedded
derivatives that must be bifurcated and accounted for separately as
derivatives.
4.3.5.4 Features Involving Certain Aspects of Credit Risk
Under ASC 815-15-15-9, there are certain features involving aspects of credit
risk that do not require evaluation of the guidance in ASC 815-10-15-11 and
ASC 815-15-25.
ASC 815-15
15-9 The transfer of
credit risk that is only in the form of
subordination of one financial instrument to another
(such as the subordination of one beneficial
interest to another tranche of a securitization,
thereby redistributing credit risk) is an embedded
derivative feature that shall not be subject to the
application of paragraph 815-10-15-11 and Section
815-15-25. Only the embedded credit derivative
feature created by subordination between the
financial instruments is not subject to the
application of paragraph 815-10-15-11 and Section
815-15-25. However, other embedded credit derivative
features (for example, those related to credit
default swaps on a referenced credit) would be
subject to the application of paragraph 815-10-15-11
and Section 815-15-25 even if their effects are
allocated to interests in tranches of securitized
financial instruments in accordance with those
subordination provisions. Consequently, the
following circumstances (among others) would not
qualify for the scope exception and are subject to
the application of paragraph 815-10-15-11 and
Section 815-15-25 for potential bifurcation:
-
An embedded derivative feature relating to another type of risk (including another type of credit risk) is present in the securitized financial instruments.
-
The holder of an interest in a tranche of that securitized financial instrument is exposed to the possibility (however remote) of being required to make potential future payments (not merely receive reduced cash inflows) because the possibility of those future payments is not created by subordination. (Note, however, that the securitized financial instrument may involve other tranches that are not exposed to potential future payments and, thus, those other tranches might qualify for the scope exception.)
-
The holder owns an interest in a single-tranche securitization vehicle; therefore, the subordination of one tranche to another is not relevant.
4.3.5.5 Features Involving Certain Currencies
Under ASC 815-15-15-10, embedded features involving certain currencies do not
require evaluation of the guidance in ASC 815-15-25.
ASC 815-15
15-10 An embedded foreign
currency derivative shall not be separated from the
host contract and considered a derivative instrument
under paragraph 815-15-25-1 if all of the following
criteria are met:
-
The host contract is not a financial instrument.
-
The host contract requires payment(s) denominated in any of the following currencies:
-
The functional currency of any substantial party to that contract
-
The currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions)
-
The local currency of any substantial party to the contract
-
The currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary (as discussed in paragraph 830-10-45-11).
-
-
Other aspects of the embedded foreign currency derivative are clearly and closely related to the host contract.
The evaluation of whether a contract qualifies for
the scope exception in this paragraph shall be
performed only at inception of the contract.
15-11 The decision about the
currency of the primary economic environment in
which a counterparty to a contract operates can be
based on available information and reasonable
assumptions about the counterparty; representations
from the counterparty are not required.
15-12 When determining who
is a substantial party to the contract for purposes
of applying paragraph 815-15-15-10(b)(1), the entity
shall do both of the following:
-
Consider all facts and circumstances pertaining to that contract (including whether the contracting party possesses the requisite knowledge, resources, and technology to fulfill the contract without relying on related parties)
-
Look through the legal form to evaluate the substance of the underlying relationships.
15-13 Example 1 (see
paragraph 815-15-55-83) illustrates the application
of this guidance.
15-14 The application of the
phrase routinely denominated in international
commerce in paragraph 815-15-15-10(b)(2) shall be
based on how similar transactions for a certain
product or service are routinely structured around
the world, not just in one local area. If similar
transactions for a certain product or service are
routinely denominated in international commerce in
various different currencies, the scope exception in
that paragraph shall not apply to any of those
similar transactions.
15-15 The guidance in
paragraph 815-15-15-10 relating to embedded foreign
currency derivatives within nonfinancial contracts
relates to all embedded foreign currency caps or
floors within such contracts. That guidance does not
relate to all embedded foreign currency options
within such contracts (such as an embedded foreign
currency option that merely introduces a cap or
floor on the functional currency equivalent price
under a purchase contract). The embedded foreign
currency cap or floor (or combination thereof)
within a nonfinancial contract shall be considered
clearly and closely related to the host nonfinancial
contract, and thus not be accounted for separately
as a derivative instrument, only if all of the
following criteria are met:
-
The nonfinancial contract requires payment(s) denominated in any of the currencies permitted by paragraphs 815-15-15-10(b).
-
The embedded cap or floor (or combination thereof) does not contain leverage features.
-
The embedded cap or floor (or combination thereof) does not represent a written or net written option.
15-16 When an embedded cap or
floor (or combination thereof) represents a
purchased or net purchased option to one party to
the contract, it represents a written or net written
option to the counterparty to that contract. In that
circumstance, that counterparty does not qualify for
the paragraph 815-15-15-10 exclusion because the
criterion in (c) in the preceding paragraph would
not be met (due to the embedded foreign currency cap
or floor [or combination thereof] representing a
written or net written option).
15-17 If the embedded
derivative represented a zero-cost collar (as
described beginning in paragraph 815-20-25-88), both
parties to the contract would meet the criterion in
paragraph 815-15-15-15(c) and be eligible to qualify
for the exclusion in paragraph 815-15-15-10.
15-18 If a financial or
nonfinancial contract contained an option that
allowed the payer to remit funds in an equivalent
amount of a currency other than the functional
currency of a substantial party to the contract at
the payment date, that option shall not be separated
from the host contract because the option merely
allows the payer to make an equivalent payment in a
choice of currencies (based on current spot
prices).
15-19 The guidance in
paragraphs 815-15-15-15 through 15-18 is not meant
to address every possible type of foreign currency
option that may be embedded in a nonfinancial
contract, and an analogy to that guidance may not be
appropriate for such foreign currency options.
The examples reproduced below illustrate the application of the guidance in
ASC 815-15-15-10(b)(1), shown above.
ASC 815-15
Example 1: Features Involving Certain
Currencies — Substantial Party to the
Contract
55-83 The following Cases
illustrate the application of paragraph
815-15-15-10(b)(1):
-
Guarantor not a substantial party to a two-party lease (Case A)
-
Requisite knowledge, resources, and technology (Case B)
-
Highly inflationary environment (Case C).
Case A: Guarantor Is Not a Substantial Party to a
Two-Party Lease
55-84 A U.S. parent entity
for which the U.S. dollar is the functional currency
has a French subsidiary with a Euro functional
currency. The subsidiary enters into a lease with a
Canadian entity for which the Canadian dollar is the
functional currency that requires lease payments
denominated in U.S. dollars. The parent entity
guarantees the lease.
55-85 The exception in
paragraph 815-15-15-10(b)(1) does not apply to the
contract. The substantial parties to a lease
contract are the lessor and the lessee; a
third-party guarantor is not a substantial party to
a two-party lease, even if it is a related party
(such as a parent entity). Thus, the functional
currency of a guarantor is not relevant to the
application of that paragraph.
55-86 The requirement in
paragraph 815-15-15-10(b)(1) that the payments be
denominated in the functional currency of at least
one substantial party to the transaction ensures
that the foreign currency is integral to the
arrangement and thus considered to be clearly and
closely related to the terms of the lease.
Case B: Requisite Knowledge, Resources, and
Technology
55-87 A U.S.-based
construction entity (the Parent) pursues business in
a foreign country on a major construction contract.
The Parent has an operating subsidiary (the
Subsidiary) in that foreign country. The
Subsidiary’s functional currency is determined to be
the local currency (because of business activities
unrelated to the construction contract), which is
also the functional currency of the customer under
the contract. The Parent’s functional currency is
the U.S. dollar.
55-88 Primarily for tax and
political reasons, the Parent causes its Subsidiary
to enter into a contract with the customer (that is,
the contract is legally between the Subsidiary and
the customer). The contract requires payments by the
customer in U.S. dollars. The payments are in U.S.
dollars to facilitate the compensation of the Parent
for its significant involvement in and management of
the contract entered into by the Subsidiary.
55-89 The Subsidiary, by
itself, does not possess the requisite financial,
human, and other resources, technology, and
knowledge to execute the construction contract on
its own. The Parent provides the majority of the
resources required under the contract, including
direct involvement in negotiating the terms of the
contract, managing and executing the contract
throughout its duration, and maintaining all
contract supporting functions, such as legal, tax,
insurance, and risk management. Because it is
controlled by the Parent, the Subsidiary does not
have a choice of subcontractor for these resources
and services and will always integrate the Parent
into all phases of the contract. Without the Parent,
the Subsidiary and the customer would probably never
have entered into the construction contract because
the Subsidiary could not perform under this contract
without the help of the Parent.
55-90 In this Case, the
Parent is a substantial party to the construction
contract entered into by the Subsidiary for the
purposes of applying paragraph 815-15-15-10(b)(1)
because the Parent will be providing the majority of
resources required under the contract on behalf of
the Subsidiary, which is the legal party to the
contract.
Case C: Highly Inflationary Environment
55-91 The following Cases
illustrate the application of the scope exception in
paragraph 815-15-15-10:
-
The contractual payments are denominated in a currency that, while not the functional currency, is used as if it were the functional currency due to a highly inflationary economy (Case C1).
-
The economy of the primary economic environment ceases to be highly inflationary after the inception of the contract (Case C2).
55-92 Cases C1 and C2 share
the following assumptions. A U.S. parent entity for
which the U.S. dollar (USD) is both the functional
currency and the reporting currency has a Venezuelan
subsidiary. The subsidiary’s sales, expenses, and
financing are primarily denominated in the Mexican
peso (MXN), and therefore the subsidiary considers
MXN to be its functional currency as required by
Topic 830. However, assume that the economy in
Mexico is highly inflationary, and therefore that
Topic requires that the parent entity’s reporting
currency (that is, USD) be used as if it were the
subsidiary’s functional currency. The subsidiary
enters into a lease with a Canadian entity for
property in Venezuela that requires the subsidiary
to make lease payments in USD. Further, assume that
the Canadian entity’s functional currency is the
Canadian dollar (CAD). The Venezuelan subsidiary’s
local currency is VEB (the Venezuelan bolivar).
Case C1: Highly Inflationary Economy
Exists
55-93 The exception in
paragraph 815-15-15-10 applies to contract because
the subsidiary uses USD as if it were the functional
currency. The conclusion is not affected by the fact
that USD is not the currency of the primary economic
environment in which either the Venezuelan
subsidiary or the Canadian lessor operates (that is,
USD is not the functional currency of either party
to the lease). The forward contract to deliver USD
embedded in the lease contract should not be
bifurcated from the lease host. The exception in
paragraph 815-15-15-10 would apply to the lease
contract in this Example if the payments under that
contract were denominated in any of the following
four currencies: USD, MXN, VEB, or CAD. The
exception applies to both of the substantial parties
to the contract, the lessor and the lessee.
Case C2: Highly Inflationary Economy Ceases to
Exist
55-94 Assume that, during
the term of the property lease, the Mexican economy
ceases to be highly inflationary. Therefore, the
Venezuelan subsidiary’s financial statements cease
to be remeasured as if USD were the functional
currency and, instead, those financial statements
are remeasured using the subsidiary’s functional
currency, MXN.
55-95 When the lease was
entered into, the subsidiary used USD as if it were
the functional currency; therefore, the foreign
currency embedded derivative would have qualified
for the exception in paragraph 815-15-15-10 for both
the lessor and the lessee. The fact that the
subsidiary subsequently ceased using USD as if it
were the functional currency and, instead, now uses
MXN (which was outside the control of management of
the entity because it is contingent upon a change in
the Mexican economy) does not affect the application
of the exception because the subsidiary qualified
for the exception at the inception of the contract.
However, if the subsidiary would enter into an
extension of the lease or a new lease that required
payments in USD, the exception would not apply
because at the time the new or extended lease was
entered into, the subsidiary no longer used USD as
if it were the functional currency.
The following example, which is reproduced from ASC 815-15-55-240 through
55-243, illustrates the application of ASC 815-15-15-15.
ASC 815-15
55-240 On March 1, 20X0,
Entity A enters into a Japanese yen- (JPY-)
denominated forward purchase agreement to purchase a
specified quantity of widgets in six months from
Entity B. Entity A’s functional currency is the U.S.
dollar (USD) and Entity B’s functional currency is
JPY. The spot JPY/USD foreign exchange rate at the
inception of the agreement is USD 1.00 equals JPY
110.00. Entity A wishes to collar its foreign
exchange rate risk by ensuring that it will never
pay more than the JPY equivalent to USD 11.00 per
widget in return for committing to Entity B that it
will never pay less than the JPY equivalent to USD
8.80 per widget. The agreement defines the price
according to the following schedule.
55-241 Entity A is exposed
to foreign exchange risk in the range between JPY
100 and JPY 125, whereas Entity B is exposed outside
that range. The following are various scenarios.
55-242 In essence, Entity A
has not locked in a USD price or a JPY price for the
purchased widgets. Instead, as desired, Entity A has
locked in a price range in its functional currency
(USD) between USD 8.80 and USD 11.00 for the
purchased widgets. The final price to be paid within
this range will be determined based on the JPY/USD
foreign exchange rate. Based on the terms, the
contract contains an embedded cap and floor
(options). For purposes of this Example, assume that
the combination of options represents a net
purchased option for Entity A.
55-243 The embedded
foreign currency options within Entity A’s purchase
contract would qualify for the exclusion under
paragraph 815-15-15-15 for purposes of Entity A’s
accounting because all of the following conditions
exist:
-
The options are denominated in JPY and USD (the functional currencies of both parties to the contract).
-
There is no leverage feature within the options.
-
The combination of foreign currency options represents a net purchased option.
Not all foreign currency embedded derivatives require
separate accounting. ASC 815-15-15-10 provides an exception for a host
contract that is not a financial instrument (e.g., an operating lease or
supply contract is not a financial instrument) if it requires payments
denominated in one of the following, as outlined in
ASC 815-15-15-10(b):
-
The functional currency of any substantial party to that contract.
-
The currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions)
-
The local currency of any substantial party to the contract
-
The currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary.
If the criteria in ASC 815-15-15-10(b) are met, the forward contract to
deliver (or receive) payment in a foreign currency is considered clearly and
closely related to the host contract and, therefore, is not an embedded
foreign currency derivative.
In accordance with ASC 815-15-15-10(b)(2), a contract for a good or service
that is “routinely denominated in international commerce” would not be a
foreign currency embedded derivative requiring separate accounting. For
example, crude oil is only quoted in U.S. dollars in international commerce;
therefore, a euro functional entity would not have an embedded derivative if
it held a contract to buy crude oil that was denominated in U.S.
dollars.
Example 4-10
International Commerce Considerations
Company A, a U.S. dollar functional currency entity,
enters into an operating lease with Company B.,
whose functional currency is the euro. Company A
will lease office space from B and pay €2,500,000
per year. From A’s perspective, embedded in the
lease is a foreign currency forward contract to buy
€2,500,000 annually over the life of the lease.
Because A is required to make lease payments in
euros, the functional currency of the lessor, A
would not account for a foreign currency embedded
derivative since it would be considered clearly and
closely related to the host contract. Alternatively,
if A was required to make lease payments in Canadian
dollars, it would have to separately account for the
foreign currency embedded derivative since Canada is
not the primary economic environment of either A or
B.
In determining the functional currency of the counterparty to a contract, the
other party does not have to inquire about the counterparty’s functional
currency but only needs to make a reasonable assumption about what its
functional currency may be. For example, assume that a Brazilian subsidiary
whose functional currency is the Real has a parent whose functional currency
is the U.S. dollar. If the parent buys inventory under a long-term
commitment at a fixed price in euros (assume that the contract is not a
derivative) from a local sales office of a German company, the Brazilian
subsidiary may conclude that the sales office has a euro functional currency
if it is merely a pass-through entity for its German parent.
Example 4-11
Determining the Functional Currency
An Australian dollar functional company, Company X,
enters into a forward contract to purchase products
in U.S. dollars from a Norwegian company, Company Y,
whose financial statements are issued in Norwegian
krone. Company Y does not follow U.S. GAAP and does
not refer to a functional currency in its financial
statements. In reviewing Y’s financial statements
and operations, X determines that Y’s primary
sources of financing are U.S. dollars and that 95
percent of its sales are generated in U.S. dollars.
Therefore, X would not have to bifurcate the U.S.
dollar forward because the U.S. dollar appears to be
Y’s primary operating currency. The primary
operating currency of a company that does not follow
U.S. GAAP should not be different from what its
functional currency would be if it followed U.S.
GAAP. In other words, an entity could not have a
functional currency that is different from its
primary operating currency.
The scope exception in ASC 815-15-15-10 also applies to certain insurance
contracts that have features that involve certain currencies.
ASC 815-15
15-20 Although the scope
exception in paragraph 815-15-15-10 does not apply
to financial instruments, that paragraph applies if
a normal insurance contract involves payment in the
functional currency of either of the two parties to
the contract.
15-21 Paragraph
815-15-15-10 applies also to a normal insurance
contract if it involves payment in the local
currency of the country in which the loss is
incurred, irrespective of the functional currencies
of the parties to the transaction.
55-1 Insurance contracts
that provide coverage for various types of property
and casualty exposure are commonly executed between
U.S.-based insurance entities and multinational
corporations that have operations in foreign
countries. The contracts may be structured to
provide for payment of claims in the functional
currency of the insurer or in the functional
currency of the entity experiencing the loss and
will typically specify the exchange rate to be
utilized in calculating loss payments.
55-2 Consider a contract
that provides for the payment of losses in U.S.
dollars (that is, the functional currency of the
insurer). Losses are reported to the insurance
entity in the functional currency of the entity
experiencing the loss, but losses are paid by the
insurer in U.S. dollars. From the perspective of the
insurer, the contract terms may provide that the
rate of exchange to be used to convert the losses
from the functional currency of the foreign entity
to the U.S. dollar for purposes of claim payments be
one of the following:
-
The rate of exchange as of the settlement date (payment date) of the claim
-
The rate of exchange as of the loss occurrence date
-
The rate of exchange at inception of the contract.
The contract described in this guidance does not
qualify as traditional insurance under paragraph
815-10-15-53(b) because it contains a foreign
currency element.
55-3 Because the insurance
entity does not record a claim liability in
accordance with Subtopic 944-40 until losses are
incurred, no foreign-currency-denominated liability
exists (that would otherwise be subject to Subtopic
830-20, as contemplated by paragraph 815-15-15-10)
during the period between the inception of the
insurance contract and the loss occurrence date.
55-4 Insurance contracts
are financial instruments that are not covered by
the scope exception in paragraph 815-15-15-10 that
applies to nonfinancial contracts; however, that
paragraph applies to this situation in which a
normal insurance contract involves payment in the
functional currency of either of the two parties to
the contract. The insurance contracts described in
this guidance are covered by the exception in
paragraph 815-15-15-10, because the insurance
contracts do not give rise to a recognized asset or
liability that would be measured under Subtopic
830-20 until an amount becomes receivable or payable
under the contract. Therefore, as discussed in
paragraph 815-15-15-20, the exception in paragraph
815-15-15-10 also applies to insurance contracts
that involve payment of losses in the functional
currency of either of the two parties to the
contract.
Footnotes
1
See Section 9.5.2 of Deloitte’s
Roadmap Distinguishing Liabilities From Equity
for further discussion of the subsequent measurement of instruments
classified in temporary equity.
4.4 Accounting for Embedded Derivatives
4.4.1 Background
This section discusses the guidance that an entity applies when it has determined
that an embedded feature must be separated from its host contract and accounted
for as a derivative under ASC 815. It addresses:
-
Initial recognition, including the identification of the terms of the host contract and the embedded derivative (see the next section).
-
Initial measurement, including the allocation of proceeds between the host debt contract and the embedded derivative, and subsequent measurement (see Section 4.4.3).
-
Embedded derivative reassessment requirements (see Section 4.4.4).
-
The accounting that applies if an entity is unable to reliably identify and measure an embedded feature that must be accounted for as a derivative (see Section 4.4.5).
-
The fair value election for hybrid financial instruments (see Section 4.4.6).
4.4.2 Initial Recognition
4.4.2.1 General
ASC 815-10
25-1 An
entity shall recognize all of its derivative
instruments in its statement of financial position
as either assets or liabilities depending on the
rights or obligations under the contracts.
Embedded derivatives should generally be presented on the balance sheet on a
combined basis with the host contract, except in circumstances in which the
embedded derivative is a liability and the host contract is equity. If a
separated embedded derivative represents a non-option feature (e.g., an
embedded forward or swap), its terms are identified in a manner that results
in a fair value of zero for the derivative at initial recognition (see the
next section). An option-based derivative is separated on the basis of the
stated terms of the hybrid instrument, which usually results in the
attribution of an initial fair value other than zero to the embedded
derivative (see Section 4.4.2.3). If a host contract
contains multiple embedded features that require bifurcation, they are
separated as one compound embedded derivative (see Section
4.4.2.4). An entity cannot impute terms that are not clearly
present in the hybrid instrument (see Section
4.3.2.5).
4.4.2.2 Identification of the Terms of a Non-Option Embedded Derivative in a Hybrid Instrument
ASC 815-15
30-4 In separating a
non-option embedded derivative from the host
contract under paragraph 815-15-25-1, the terms of
that non-option embedded derivative shall be
determined in a manner that results in its fair
value generally being equal to zero at the inception
of the hybrid instrument. Because a loan and an
embedded derivative can be bundled in a structured
note that could have almost an infinite variety of
stated terms, it is inappropriate to necessarily
attribute significance to every one of the note’s
stated terms in determining the terms of the
non-option embedded derivative. If a non-option
embedded derivative has stated terms that are
off-market at inception, that amount shall be
quantified and allocated to the host contract
because it effectively represents a borrowing. (This
paragraph does not address the bifurcation of the
embedded derivative by a holder who has acquired the
hybrid instrument from a third party after the
inception of that hybrid instrument.) The non-option
embedded derivative shall contain a notional amount
and an underlying consistent with the terms of the
hybrid instrument. Artificial terms shall not be
created to introduce leverage, asymmetry, or some
other risk exposure not already present in the
hybrid instrument. Generally, the appropriate terms
for the non-option embedded derivative will be
readily apparent. Often, simply adjusting the
referenced forward price (pursuant to documented
legal terms) to be at the market for the purpose of
separately accounting for the embedded derivative
will result in that non-option embedded derivative
having a fair value of zero at inception of the
hybrid instrument.
Example 12:
Separating a Non-Option Embedded
Derivative
55-160 This Example
illustrates the application of paragraph 815-15-30-4
and assumes that the illustrative non-option
embedded derivative is a plain-vanilla forward
contract with symmetrical risk exposure and that the
hybrid instrument was newly entered into by the
parties to the contract. Assume that the hybrid
instrument is not a derivative instrument in its
entirety.
55-161 Entity A plans to
advance Entity X $900 for 1 year at a 6 percent
interest rate and concurrently enter into an
equity-based derivative instrument in which it will
receive any increase or pay any decrease in the
current market price ($200) of XYZ Corporation’s
common stock. Those two transactions (that is, the
loan and the derivative instrument) can be bundled
in a structured note that could have almost an
infinite variety of terms. The following presents 5
possible contractual terms for the structured note
that would be purchased by Entity A for $900:
-
Note 1: Entity A is entitled to receive at the end of 1 year $954 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $200.
-
Note 2: Entity A is entitled to receive at the end of 1 year $955 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $201.
-
Note 3: Entity A is entitled to receive at the end of 1 year $755 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $1.
-
Note 4: Entity A is entitled to receive at the end of 1 year $1,054 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $300.
-
Note 5: Entity A is entitled to receive at the end of 1 year $1,060 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $306.
55-162 All of these five
terms of a structured note will provide the same
cash flows, given a specified market price of XYZ
Corporation’s common stock. If the market price of
XYZ Corporation’s common stock at the end of 1 year
is still $200, Entity A will receive $954 under all
5 note terms. If the market price of XYZ
Corporation’s common stock at the end of 1 year
increases to $306, Entity A will receive $1,060
under all 5 note terms.
55-163 For simplicity in
constructing this Example, it is assumed that an
equity-based cash-settled forward contract with a
strike price equal to the stock’s current market
price has a zero fair value. In many circumstances,
a zero-value forward contract can have a strike
price greater or less than the stock’s current
market price.
55-164 The differences in the
terms for these five notes are totally arbitrary
because those differences have no effect on the
ultimate cash flows under the structured note; thus,
those differences are nonsubstantive and should have
no influence on how the terms of an embedded
derivative are identified. Therefore, the separation
of the hybrid instrument into an embedded derivative
and a host debt instrument should be the same for
all five terms described above for the structured
note (because they are merely different descriptions
of the same ultimate cash flows). That bifurcation
would generally result in the structured note being
accounted for as a debt host contract with an
initial carrying amount of $900 and a fixed annual
rate of interest of 6 percent and an embedded
forward contract with a $200 forward price, which
results in an initial fair value of zero. Instead,
if the five notes were bifurcated based on all their
contractual terms, such bifurcation would be the
equivalent of simply marking an arbitrary portion of
a debt instrument to market based on nonsubstantive
arbitrary differences in those contractual terms —
an inappropriate outcome.
An embedded derivative that does not involve any optionality (i.e., an
embedded forward or swap) is separated from the host contract in a manner
such that its fair value is zero when the hybrid instrument is first
recognized (i.e., it is assumed that the entity received or paid no amount
for the embedded feature). All of the proceeds of the hybrid instrument are
allocated to the host contract; none are allocated to the embedded
derivative upon initial recognition (see Section
4.4.3.1).
Accordingly, an entity cannot necessarily rely on the stated terms of the
embedded feature for separation purposes. If the stated terms imply that the
embedded feature would have some fair value at inception, those terms are
redefined and calibrated so that the embedded feature instead has zero fair
value at inception. For example, a stated forward price might need to be
increased or decreased for separation purposes with an equal and offsetting
adjustment to the manner in which the terms of the host contract are
identified. The purpose of this requirement is to ensure that the host
contract component in a hybrid financial instrument is not attributed to an
embedded derivative. If a non-option embedded derivative were to be
separated on terms that result in an initial fair value other than zero
(i.e., on “off-market” terms), the amount attributed to the embedded
derivative effectively represents a component of the host contract (e.g., a
debt element since the off-market element is “repaid” upon contract
settlement).
4.4.2.3 Identification of the Terms of an Option-Based Embedded Derivative
ASC 815-15
30-6 The terms of an
option-based embedded derivative shall not be
adjusted to result in the embedded derivative being
at the money at the inception of the hybrid
instrument. In separating an option-based embedded
derivative from the host contract under paragraph
815-15-25-1, the strike price of the embedded
derivative shall be based on the stated terms
documented in the hybrid instrument. As a result,
the option-based embedded derivative at inception
may have a strike price that does not equal the
market price of the asset associated with the
underlying. The guidance in this paragraph addresses
both of the following:
-
The bifurcation of the option-based embedded derivative by a holder who has acquired the hybrid instrument from a third party either at inception or after inception of that hybrid instrument
-
The bifurcation of the option-based embedded derivative by the issuer when separate accounting for that embedded derivative is required.
An embedded derivative that involves optionality is separated on the basis of
the stated terms of the hybrid instrument (e.g., the strike price specified
in the hybrid instrument). Under ASC 815-15-30-6, an entity is not permitted
to identify terms of an option-based embedded derivative that are different
from those in the hybrid instrument. For example, an entity cannot adjust
the manner in which the option is identified so as to achieve an intrinsic
option value of zero at inception. Economically, an embedded derivative that
involves optionality is different from a non-option embedded derivative
because it is possible that the option will never be exercised.
4.4.2.4 Multiple Embedded Derivative Features
ASC 815-15
25-7 If a hybrid instrument
contains more than one embedded derivative feature
that would individually warrant separate accounting
as a derivative instrument under paragraph
815-15-25-1, those embedded derivative features
shall be bundled together as a single, compound
embedded derivative that shall then be bifurcated
and accounted for separately from the host contract
under this Subtopic unless a fair value election is
made pursuant to paragraph 815-15-25-4.
25-8 An entity shall not
separate a compound embedded derivative into
components representing different risks (for
example, based on the risks discussed in paragraphs
815-20-25-12[f] and 815-20-25-15[i]) and then
account for those components separately.
25-9 If a compound embedded
derivative comprises multiple embedded derivative
features that all involve the same risk exposure
(for example, the risk of changes in market interest
rates, the creditworthiness of the obligor, or
foreign currency exchange rates), but those embedded
derivative features differ from one another by
including or excluding optionality or by including a
different optionality exposure, an entity shall not
separate that compound embedded derivative into
components that would be accounted for
separately.
25-10 If some of the embedded
derivative features in a hybrid instrument are
clearly and closely related to the economic
characteristics and risks of the host contract,
those embedded derivative features shall not be
included in the compound embedded derivative that is
bifurcated from the host contract and separately
accounted for.
If a hybrid contract contains more than one embedded feature that requires
bifurcation under ASC 815-15-25-1, those embedded derivatives must be
bundled together as a single compound embedded derivative. For example, an
entity cannot separate multiple embedded derivatives and designate only some
as hedging instruments. The compound embedded derivative that is separated
should not include embedded features that are evaluated separately and do
not qualify for separation (e.g., features that are considered clearly and
closely related to the host contract or qualify for a derivative scope
exception).
4.4.3 Measurement
4.4.3.1 Initial Measurement (Including Allocation)
ASC 815-10
30-1 All
derivative instruments shall be measured initially
at fair value.
ASC 815-15
30-2 The
allocation method that records the embedded
derivative at fair value and determines the initial
carrying value assigned to the host contract as the
difference between the basis of the hybrid
instrument and the fair value of the embedded
derivative shall be used to determine the carrying
values of the host contract component and the
embedded derivative component of a hybrid instrument
if separate accounting for the embedded derivative
is required by this Subtopic. (Note that Section
815-15-25 allows for a fair value election for
hybrid financial instruments that otherwise would
require bifurcation.)
30-3 The
objective is to estimate the fair value of the
derivative features separately from the fair value
of the nonderivative portions of the contract.
Estimates of fair value shall reflect all relevant
features of each component. For example, an embedded
purchased option that expires if the contract in
which it is embedded is prepaid would have a
different value than an option whose term is a
specified period that is not subject to
truncation.
An entity is required to use a “with-and-without” method to
allocate the cost basis between a bifurcated derivative and the host
contract. Under this method, (1) a portion of the basis of the hybrid
instrument (e.g., debt proceeds allocable to a hybrid debt instrument) equal
to the fair value of the derivative component is allocated to the bifurcated
derivative and then (2) the remaining carrying amount of the hybrid
instrument is allocated to the host contract. Application of this method
will not result in recognition of an immediate gain or loss in earnings
related to the derivative because the initial carrying amount of the
derivative will be its fair value.
Example 4-12
Initial
Recognition of Embedded Derivative in a Debt
Contract
Company ABC issues $100 million of
10-year, 4 percent fixed-rate convertible debt in
$1,000 denominations. Each $1,000 bond is
convertible into 20 common shares of ABC stock.
Assume that the conversion option meets the
definition of a derivative instrument and must be
bifurcated and accounted for separately. At
issuance, the fair value of the conversion option is
$100 per $1,000 bond or $10 million in aggregate.
The issuer would initially recognize the conversion
option liability at $10 million and the host debt
instrument at $90 million.
Preferred stock issued with a bifurcated embedded feature
could similarly result in the initial recognition of preferred stock at a
discount or premium. Application of the guidance in ASC 480-10-S99-3A
creates additional complexities, as highlighted in the following example.
For further details on the SEC’s guidance on temporary equity, see Chapter 9 of
Deloitte’s Roadmap Distinguishing Liabilities From Equity.
Example 4-13
Initial Carrying
Amount of Redeemable Preferred Stock With a
Bifurcated Embedded Derivative
Issuer A issues preferred stock for
net proceeds of $100. The stock is redeemable by the
holder at any time for $98. Further, the stock
contains a call option with an exercise price
indexed to a foreign currency. Assume that A
concludes that it should bifurcate the embedded call
option. If the initial amount allocated to the
embedded derivative is $5 (an asset), the initial
carrying amount of the host contract after
separation of the embedded derivative is $105.
Therefore, the initial carrying amount presented in
temporary equity is $105. Even though the redemption
value is $98, A cannot reduce the amount of
temporary equity to this amount because the SEC
precludes reductions in the amount of temporary
equity recorded for a redeemable equity instrument
below the initial carrying amount unless an
exception applies (see Section 9.5.2.5
of Deloitte’s Roadmap Distinguishing
Liabilities From Equity).
It is also possible that an embedded derivative would need
to be bifurcated from a host contract that has no initial cost basis (such
as a lessor’s operating lease or a supply contract). In such an instance,
there would be no allocation of the “remaining carrying amount” and the
entity would instead simply record the host contract at an offsetting
amount. Unlike the bifurcated embedded derivative, the host contract would
not be subject to recurring fair value measurement. Instead, it would follow
generally accepted accounting principles applicable to that type of
contract.
Example 4-14
Initial
Recognition of a Bifurcated Embedded Derivative
From an Operating Lease
Lessor L enters into an operating
lease of a building with Lessee P. Lessee P is
required to make lease payments of $1,000 per month
to L during the lease’s five-year term; however, if
the price of oil exceeds $100 per barrel, P must
make an additional lease payment of $200 per month
for as long as the price of oil exceeds $100. Lessor
L concludes that it should bifurcate the oil price
payment feature from its operating lease, and the
initial amount allocated to the embedded derivative
is $8 (an asset). Since there is no initial basis
for the lessor’s operating lease, L would simply
record an offsetting entry for $8 as a lease
liability. That liability would be released over the
life of the lease and treated as a reduction of
lease payments received.
At the 2014 AICPA Conference on Current SEC and PCAOB
Developments, then SEC Professional Accounting Fellow Hillary Salo discussed
situations in which entities enter into financing arrangements in which the
total net proceeds received for an issued hybrid instrument are less than
the fair value of the related financial liabilities that must be measured at
fair value. These scenarios can occur if an entity wishes to align itself
with a strategic investor or needs financing because of financial
difficulties. For example, an entity that wants to align itself with a
specific investor may issue $15 million of convertible debt at par and be
required to bifurcate an in-the-money conversion option with a fair value of
$20 million.
When a reporting entity issues a hybrid instrument and must
recognize related financial liabilities (e.g., an embedded derivative that
must be bifurcated) at fair values that exceed the total net proceeds
received, the entity should perform a detailed analysis of the financing
transaction. Its analysis should include:
-
Verifying that the financial liabilities that must be measured at fair value are appropriately valued under ASC 820.
-
Determining whether the transaction was conducted at arm’s length and whether the parties involved are related parties under ASC 850.
-
Evaluating all elements of the transaction to determine whether there are any other rights or privileges received that should be recognized as an asset under other applicable guidance.
If, after performing this analysis, the entity concludes
that the amount of financial liabilities measured at fair value still
exceeds the total net proceeds received, it should recognize the excess as a
loss in earnings. In addition, the entity should disclose the nature of the
transaction in the financial statement footnotes, including (1) the reasons
why the entity entered into the transaction and (2) the benefits received.
If, however, the entity determines that the transaction was not conducted at
arm’s length or was executed with a related party, it should consider
consulting with the SEC staff or the entity’s accounting advisers before
reaching a conclusion about the appropriate accounting treatment.
4.4.3.2 Subsequent Measurement
ASC 815-10
35-1 All derivative
instruments shall be measured subsequently at fair
value.
When an entity is required to bifurcate an embedded derivative from a hybrid
instrument, it accounts for the host contract under the requirements that
apply to such contracts. The accounting for the host contract is based on
the contractual cash flows that remain after separation of the cash flows
attributable to the embedded derivative. The embedded derivative is
accounted for at fair value, with changes in fair value recognized in
earnings (unless it is designated as a hedging instrument in a qualifying
cash flow hedge or net investment hedge under ASC 815, in which case fair
value changes are recognized in OCI). Importantly, although the bifurcated
embedded derivative is remeasured, the host contract is not subject to
recurring fair value measurement; instead, the accounting depends on the
applicable framework for the host contract.
For example, if debt was issued at par and contains an embedded redemption
feature that must be bifurcated as a derivative liability under ASC 815-15,
the allocation of value to the derivative liability creates a debt discount
upon issuance (see Section 4.3.6 of
Deloitte’s Roadmap Issuer’s Accounting for
Debt). In that instance, the application of the
interest method to a debt host contract depends on the amount of proceeds
and subsequent contractual cash flows that are attributed to the debt host
contract.
ASC 480-10-S99-3A does not specifically address the subsequent measurement of
hybrid instruments recorded outside of permanent equity after any embedded
derivative or derivatives have been separated from the host contract. We
believe there are two possible subsequent measurement alternatives that
would be acceptable when consistently applied as illustrated in the example
below.
Example 4-15
Subsequent Measurement of Host Contract
A convertible preferred stock instrument is
redeemable for cash at the greater of (1) the
conversion value and (2) the original issue price
plus accrued cumulative unpaid dividends. The issuer
has concluded that the conversion option must be
bifurcated as a derivative under ASC 815-15
(including a portion of the cash-settled redemption
feature equal to the difference between the
conversion value and the original issue price plus
accrued and cumulative unpaid dividends). The
instrument is not currently redeemable, but it is
probable that it will become redeemable.
The two acceptable views regarding subsequent
measurement of the preferred stock instrument are as follows:
-
View A — The entity could accrete or immediately adjust the host contract to the redemption amount on the basis of the original issue price plus accrued cumulative unpaid dividends. Under this approach, the value of the host contract upon remeasurement would not reflect the possibility of a redemption based on the conversion value because the conversion spread would be recognized separately as a derivative liability.
-
View B — The entity could adjust the carrying amount of the host contract to an amount equal to the instrument’s maximum redemption value less the current carrying amount of the bifurcated derivative liability.
Importantly, the application of Views A and B could
result in differences in the total amounts assigned
to the sum of the host contract plus the bifurcated
feature. For example, if the fair value of the
bifurcated conversion feature increased, there may
or may not be a change in the carrying amount of the
host contract under View B, depending on whether the
hybrid instrument’s redemption value increases by
the same amount as the increase in the bifurcated
conversion option’s fair value. In many cases, the
redemption value of the hybrid instrument would not
include the time value of the conversion option. In
addition, if the redemption value of the hybrid
instrument increases partly because of increases in
the intrinsic value of the conversion option, that
portion of the increase in fair value would not
result in a change in the carrying amount of the
host contract. In that case, the fair value of the
bifurcated conversion feature would be the same
regardless of whether the entity applies View A or
View B but the value assigned to the host contract
could be different.
4.4.4 Reassessment
4.4.4.1 General
ASC 815-10
25-2 If a
contract that did not meet the definition of a
derivative instrument at acquisition by the entity
meets the definition of a derivative instrument
after acquisition by the entity, the contract shall
be recognized immediately as either an asset or
liability with the offsetting entry recorded in
earnings.
25-3 If a
contract ceases to be a derivative instrument
pursuant to this Subtopic and an asset or liability
had been recorded for that contract, the carrying
amount of that contract becomes its cost basis and
the entity shall apply other generally accepted
accounting principles (GAAP) that are applicable to
that contract prospectively from the date that the
contract ceased to be a derivative instrument. If
the derivative instrument had been designated in a
cash flow hedging relationship and a gain or loss is
recorded in accumulated other comprehensive income,
then the guidance in Sections 815-30-35 and
815-30-40 shall be applied accordingly.
30-3 A
contract recognized under paragraph 815-10-25-2
because it meets the definition of a derivative
instrument after acquisition by an entity shall be
measured initially at its then-current fair
value.
ASC 815-40
35-8 The
classification of a contract (including freestanding
financial instruments and embedded features) shall
be reassessed at each balance sheet date. If the
classification required under this Subtopic changes
as a result of events during the period (if, for
example, as a result of voluntary issuances of stock
the number of authorized but unissued shares is
insufficient to satisfy the maximum number of shares
that could be required to net share settle the
contract [see discussion in paragraph
815-40-25-20]), the contract shall be reclassified
as of the date of the event that caused the
reclassification. There is no limit on the number of
times a contract may be reclassified.
50-3
Contracts within the scope of this Subtopic may be
required to be reclassified into (or out of) equity
during the life of the instrument (in whole or in
part) pursuant to the provisions of paragraphs
815-40-35-8 through 35-13. An issuer shall disclose
contract reclassifications (including partial
reclassifications), the reason for the
reclassification, and the effect on the issuer’s
financial statements.
An entity should continually reassess whether an embedded feature qualifies
as a derivative and, if so, for any derivative scope exception. For example,
an entity is required to reassess whether the net settlement characteristic
in the definition of a derivative is met (see Section
4.3.4). If an embedded feature begins or ceases to meet the
definition of a derivative or any scope exception, the analysis of whether
the feature should be separated and accounted for as a derivative under ASC
815 is affected.
Unlike the evaluation of whether the embedded feature is a derivative, the
evaluation of whether an embedded feature is clearly and closely related to
its host contract is performed at the inception of the contract only and is
not subject to reassessment.
If separation of an embedded derivative is required after the initial
recognition of a hybrid instrument, the feature is bifurcated and recognized
at fair value at the time it begins to meet the bifurcation criteria (see
Section 4.3). In the case of a
hybrid instrument, a portion of the current carrying amount of the hybrid
instrument equal to the current fair value of the feature as of the
reclassification date is reallocated to the embedded derivative in a manner
consistent with the allocation guidance in ASC 815-15-30-2 (see
Section 4.4.3.1).
Conversely, if separation of an embedded feature is no longer required after
the initial recognition of a hybrid instrument, the embedded derivative is
recombined with its host contract at its current fair value at the time it
ceases to meet the bifurcation criteria. However, special guidance applies
to bifurcated equity conversion features (see Section
4.4.4.3).
Example 4-16
Reassessment of Embedded Features in a Preferred
Stock Arrangement
Entity A issues convertible
preferred stock that contains a debt host contract
it is evaluating for potential bifurcation of the
embedded features under ASC 815-15. The conversion
feature embedded in the debt host contract does not
initially meet the definition of a derivative since
(1) the feature cannot be contractually net settled
and (2) neither the preferred stock nor the shares
issuable upon the stock’s conversion are publicly
traded (and therefore are not RCC as defined by ASC
815-10). After the initial issuance of the preferred
stock, A successfully completes an IPO, and the
level of market trading is sufficient to rapidly
absorb the shares issuable upon conversion of the
preferred stock without significantly affecting the
stock price (i.e., the shares become RCC).
Accordingly, before considering the applicability of
any derivative scope exceptions, A would be required
to bifurcate the embedded conversion feature upon
the IPO, even though the terms of the convertible
preferred stock itself are not amended.
4.4.4.2 Conversion Feature Ceases to Qualify for the Own Equity Scope Exception
ASC 815-40
35-9 . . . If
an embedded feature no longer qualifies for the
derivatives scope exception under this Subtopic, the
feature shall be separated from its host contract
and accounted for as a derivative instrument in
accordance with Subtopic 815-10 and Subtopic 815-15
(if all of the criteria in paragraph 815-15-25-1 are
met).
If separation of an embedded equity conversion feature is required after the
initial recognition of a convertible instrument, the feature is bifurcated
and recognized at fair value at the time it begins to meet the bifurcation
criteria (see Section 4.3). A portion
of the current carrying amount of the instrument equal to the current fair
value of the embedded derivative feature as of the reclassification date is
reallocated to the embedded derivative in a manner consistent with the
allocation guidance in ASC 815-15-30-2 (see Section
4.4.3.1). The entity also should provide the disclosures
required by ASC 815-40-50-3.
4.4.4.3 Conversion Feature Ceases to Be Bifurcated as a Derivative
ASC 815-15
35-4 If an
embedded conversion option in a convertible debt
instrument no longer meets the bifurcation criteria
in this Subtopic, an issuer shall account for the
previously bifurcated conversion option by
reclassifying the carrying amount of the liability
for the conversion option (that is, its fair value
on the date of reclassification) to shareholders’
equity. Any debt discount recognized when the
conversion option was bifurcated from the
convertible debt instrument shall continue to be
amortized.
40-1 If a
holder exercises a conversion option for which the
carrying amount has previously been reclassified to
shareholders’ equity pursuant to paragraph
815-15-35-4, the issuer shall recognize any
unamortized discount remaining at the date of
conversion immediately as interest expense.
40-4 If a
convertible debt instrument with a conversion option
for which the carrying amount has previously been
reclassified to shareholders’ equity pursuant to the
guidance in paragraph 815-15-35-4 is extinguished
for cash (or other assets) before its stated
maturity date, the entity shall do both of the
following:
-
The portion of the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment shall be allocated to equity.
-
The remaining reacquisition price shall be allocated to the extinguishment of the debt to determine the amount of gain or loss.
50-3 An
issuer shall disclose both of the following for the
period in which an embedded conversion option
previously accounted for as a derivative instrument
under this Subtopic no longer meets the separation
criteria under this Subtopic:
-
A description of the principal changes causing the embedded conversion option to no longer require bifurcation under this Subtopic
-
The amount of the liability for the conversion option reclassified to stockholders’ equity.
ASC 815-40
35-10 . . .
An embedded derivative that qualifies for the
derivatives scope exception upon reassessment under
this Subtopic that was separated from its host
contract and accounted for as a derivative
instrument in accordance with Subtopic 815-10 shall
be reclassified to equity. The previously bifurcated
embedded derivative shall not be recombined with its
host contract.
If a previously bifurcated embedded conversion option ceases to meet the ASC
815-15 bifurcation criteria, any previously recognized gains and losses
should not be reversed. Instead, the carrying amount of the embedded
derivative (i.e., the feature’s fair value as of the date of the
reclassification) should be reclassified to shareholders’ equity (see
Section 6.4 of Deloitte’s Roadmap
Contracts on an Entity’s Own
Equity). The entity also should provide the disclosures
required by ASC 815-15-50-3 and ASC 815-40-50-3.
Example 4-17
Reassessment of an Embedded Feature That May No
Longer Meet the Definition of a Derivative
Entity B issues convertible preferred stock that
contains a debt host it is evaluating for potential
bifurcation of the embedded features under ASC
815-15. The conversion feature embedded in the debt
host contract meets the definition of a derivative
since the feature requires gross settlement by
delivery of shares that are RCC as defined by ASC
815-10. The scope exception for contracts indexed to
an entity’s own equity does not apply because the
convertible preferred stock’s conversion feature
includes adjustments that are precluded under ASC
815-40. Accordingly, the conversion feature is
bifurcated and accounted for separately as if it
were a freestanding derivative.
After the initial issuance of the convertible
preferred stock, all of B’s common stock is acquired
by a private equity partnership, and the stock is no
longer publicly traded. Accordingly, B should
reevaluate whether the embedded conversion feature
still requires bifurcation upon the acquisition,
even though the terms of the convertible preferred
stock itself are not amended. If the conversion
feature requires gross settlement (i.e., an exchange
of preferred stock for nonpublic common stock), it
would typically no longer meet the definition of a
derivative and therefore no longer require
bifurcation after the private equity
acquisition.
Example 4-18
Convertible Debt With a Conversion Option That No
Longer Requires Bifurcation
On January 1, 20X5, Company ABC
issues a 10-year note that has a $1,000 par value,
accrues interest at an annual rate of 4 percent, and
is convertible into 100 shares of ABC common stock.
The fair value of one share of ABC’s common stock is
$4.50 on the issue date. Upon conversion, ABC must
settle the accreted value of the note in cash and
has the option to settle the conversion spread in
either cash or common stock (commonly referred to as
Instrument C2). After considering its potential share
requirements for other existing commitments, ABC
concludes that it cannot assert that it has a
sufficient number of authorized but unissued common
shares available to share settle the conversion
option; accordingly, the conversion option does not
qualify for equity classification under ASC 815-40.
After applying ASC 815-40 and ASC 815-15-25-1, ABC
concludes that the conversion option must be
bifurcated and accounted for as a separate
derivative.
At inception, on January 1, 20X5, ABC records the
entry below to bifurcate the embedded derivative.
The fair value of the conversion option on that date
is $50.
Journal Entry: January 1, 20X5
As of each quarterly reporting date, ABC determines
that continued bifurcation of the conversion option
is required. For each quarterly reporting period,
the derivative (which is not designated as a hedging
instrument) is marked to fair value, with the
changes in fair value recognized in earnings.
Company ABC also recognizes its contractual interest
expense on the note, and the debt discount created
by the bifurcation of the embedded conversion option
is amortized to interest expense. The following
journal entries reflect the cumulative activity
booked during the year ended December 31, 20X5 (each
journal entry represents the sum of the quarterly
journal entries):
Journal Entry: Year Ended December 31,
20X5
As of December 31, 20X5, the carrying amounts of the
debt host contract and the conversion liability are
$955 and $200, respectively.
On January 1, 20X6, ABC obtains shareholder approval
to increase the number of its authorized common
shares to a level sufficient for it to assert that
it has the ability to share settle the conversion
option. On the basis of this approval, ABC concludes
that the conversion option now qualifies for equity
classification under ASC 815-40 and that the
bifurcated derivative liability no longer needs to
be accounted for as a separate derivative under ASC
815-15-25-1.
Company ABC believes that no modification of terms
occurred. Rather, an event extraneous to the note
(obtaining shareholder approval to increase
authorized common shares) has caused the embedded
conversion option to no longer meet the conditions
for bifurcation.
Company ABC records the following entry on January 1,
20X6 (assume no changes in fair values from December
31, 20X5, to January 1, 20X6).
Journal Entry: January 1, 20X6
Note that the debt discount will continue to be
amortized over the remaining term of the debt since
this discount reflects the issuer’s economic
borrowing costs related to the convertible debt
instrument. Company ABC also would be required to
provide the disclosures described in ASC 815-15-50-3
and ASC 815-40-50-3.
4.4.5 Inability to Reliably Identify and Measure Embedded Derivative
4.4.5.1 Recognition and Measurement
ASC 815-15
30-1 An
entity shall measure both of the following initially
at fair value: . . .
b. An entire hybrid instrument if an entity
cannot reliably identify and measure the embedded
derivative that paragraph 815-15-25-1 requires be
separated from the host contract.
35-2 If an
entity cannot reliably identify and measure the
embedded derivative that paragraph 815-15-25-1
requires be separated from the host contract, the
entire contract shall be measured subsequently at
fair value with gain or loss recognized in earnings.
Paragraph 815-20-25-71(a)(4) states that the entire
contract shall not be designated as a hedging
instrument pursuant to Subtopic 815-20.
In the unusual situation in which an entity cannot reliably identify and
measure an embedded feature that is required to be separated as a
derivative, the entity must record the entire hybrid instrument at fair
value and recognize changes in fair value through earnings. In practice,
this provision is rarely applied. Note that under no circumstance can such
an instrument be designated as a hedging instrument under ASC 815-20.
4.4.5.2 Presentation
ASC 815-15
45-1 In each statement of
financial position presented, an entity shall report
hybrid financial instruments measured at fair value
under the election and under the practicability
exception in paragraph 815-15-30-1 in a manner that
separates those reported fair values from the
carrying amounts of assets and liabilities
subsequently measured using another measurement
attribute on the face of the statement of financial
position. To accomplish that separate reporting, an
entity may do either of the following:
-
Display separate line items for the fair value and non-fair-value carrying amounts
-
Present the aggregate of the fair value and non-fair-value amounts and parenthetically disclose the amount of fair value included in the aggregate amount.
If an entity accounts for a hybrid instrument at fair value, it must report
the related fair value amounts separately on the face of the balance sheet
under ASC 815-15-45-1.
4.4.5.3 Disclosure
ASC 815-15
50-1 For
those hybrid financial instruments measured at fair
value under the election and under the
practicability exception in paragraph 815-15-30-1,
an entity shall also disclose the information
specified in paragraphs 825-10-50-28 through
50-32.
50-2 An
entity shall provide information that will allow
users to understand the effect of changes in the
fair value of hybrid financial instruments measured
at fair value under the election and under the
practicability exception in paragraph 815-15-30-1 on
earnings (or other performance indicators for
entities that do not report earnings).
If an entity accounts for a hybrid instrument at fair value
because it cannot reliably identify and measure an embedded derivative (see
Section
4.4.5.1), it must provide the disclosures that are required
for financial liabilities for which the fair value option in ASC 825-10 has
been elected (see Chapter
12 of Deloitte’s Roadmap Fair Value Measurements and Disclosures
(Including the Fair Value Option)).
4.4.6 Fair Value Election for Hybrid Financial Instruments
4.4.6.1 Eligibility
ASC 815-15
25-4 An
entity that initially recognizes a hybrid financial
instrument that under paragraph 815-15-25-1 would be
required to be separated into a host contract and a
derivative instrument may irrevocably elect to
initially and subsequently measure that hybrid
financial instrument in its entirety at fair value
(with changes in fair value recognized in earnings
and, if paragraph 825-10-45-5 is applicable, other
comprehensive income). A financial instrument shall
be evaluated to determine that it has an embedded
derivative requiring bifurcation before the
instrument can become a candidate for the fair value
election.
25-5 The fair
value election shall be supported by concurrent
documentation or a preexisting documented policy for
automatic election. That recognized hybrid financial
instrument could be an asset or a liability and it
could be acquired or issued by the entity. The fair
value election is also available when a previously
recognized financial instrument is subject to a
remeasurement event (new basis event) and the
separate recognition of an embedded derivative. The
fair value election may be made instrument by
instrument. For purposes of this paragraph, a
remeasurement event (new basis event) is an event
identified in generally accepted accounting
principles, other than the recognition of an
other-than-temporary impairment, or measurement of
an impairment loss through earnings under Topic 321
on equity investments, that requires a financial
instrument to be remeasured to its fair value at the
time of the event but does not require that
instrument to be reported at fair value on a
continuous basis with the change in fair value
recognized in earnings. Examples of remeasurement
events are business combinations and significant
modifications of debt as defined in Subtopic
470-50.
Pending Content (Transition Guidance: ASC
326-10-65-1)
25-5 The fair value election shall be
supported by concurrent documentation or a
preexisting documented policy for automatic
election. That recognized hybrid financial
instrument could be an asset or a liability and it
could be acquired or issued by the entity. The
fair value election is also available when a
previously recognized financial instrument is
subject to a remeasurement event (new basis event)
and the separate recognition of an embedded
derivative. The fair value election may be made
instrument by instrument. For purposes of this
paragraph, a remeasurement event (new basis event)
is an event identified in generally accepted
accounting principles, other than the recording of
a credit loss under Topic 326, or measurement of
an impairment loss through earnings under Topic
321 on equity investments, that requires a
financial instrument to be remeasured to its fair
value at the time of the event but does not
require that instrument to be reported at fair
value on a continuous basis with the change in
fair value recognized in earnings. Examples of
remeasurement events are business combinations and
significant modifications of debt as defined in
Subtopic 470-50.
25-6 The fair
value election shall not be applied to the hybrid
instruments described in paragraph 825-10-50-4.
Under ASC 815-15-25-1, an entity may be required to bifurcate and separately
account for an embedded derivative contained within a hybrid instrument. In
lieu of such separation, ASC 815-15-25-4 allows an entity to account for the
entire hybrid instrument at fair value, provided that the instrument is a
financial asset or financial liability, with changes recognized in earnings
and, if applicable, OCI. The fair value measurement election applies to
hybrid financial instruments that are issued as well as those that are
purchased.
The fair value election in ASC 815-15 originated from the
guidance in FASB Statement 155, which was issued before FASB Statement 159
(which provided the pre-Codification fair value option guidance now
contained in ASC 825-10; see Section
4.4). The fair value election in ASC 815-15 can be made on an
instrument-by-instrument basis, or an entity can elect this option for all
qualifying hybrid financial instruments on some other basis, such as an
entity-wide policy decision or a type-of-instrument basis. In all scenarios,
the fair value election under ASC 815-15 must be supported with appropriate
concurrent documentation that eliminates any question regarding whether the
entity elected to apply fair value measurement to a particular
instrument.
In ASC 815-15-25-5, the term “concurrent documentation” is analogous to the
“contemporaneous documentation” requirements for hedge accounting in ASC
815. Therefore, the fair value election for hybrid financial instruments
must be documented (1) at the time a hybrid financial instrument is acquired
or issued or (2) when a previously recognized hybrid financial instrument is
subject to a remeasurement (new basis) event. If the documentation does not
exist at that time, the fair value option may not be elected.
A remeasurement event, as prescribed in ASC 825-10-25-5, may
provide the entity with another opportunity to elect to measure the entire
hybrid financial instrument at fair value provided that concurrent
documentation is prepared to support that election.3
For the following reasons, the fair value election in ASC 815-15 applies to a
narrower population (scope) of items than the fair value option in ASC 825-10:
-
The fair value election in ASC 815-15 applies only to hybrid financial instruments for which bifurcation of an embedded derivative would otherwise be required. An entity that elects the fair value option in ASC 825-10 is not required to determine that an embedded derivative would need to be accounted for separately under ASC 815-15.
-
ASC 815-15-25-6 prohibits the fair value election for any hybrid instrument that is discussed in ASC 825-10-50-8, which describes 15 items for which public business entities are not required to provide fair value disclosures. The scope of ASC 825-10-50-8 is more restrictive than the scope of the fair value option in ASC 825-10-15-4 and 15-5 (see Section 4.4.2).
Like ASC 825, ASC 815-15 allows the fair value election for an eligible item
only upon (1) initial recognition or (2) the occurrence of a subsequent
remeasurement event (i.e., a subsequent remeasurement of the entire
instrument at fair value under other U.S. GAAP). Therefore, under both ASC
815-15 and ASC 825, an entity is prohibited from making the fair value
election upon determining that an embedded derivative that was previously
not bifurcated under ASC 815-15 subsequently must be bifurcated (e.g., a
hybrid financial instrument containing an embedded derivative that meets the
net settlement condition in ASC 815-10-15-83(c) after initial
recognition).
There are no situations in which an entity could make the fair value election
for a hybrid instrument under ASC 815-15 but would be prohibited from
electing the fair value option for the same instrument under ASC 825-10. In
addition, regardless of whether the entity applies the fair value accounting
guidance in ASC 815-15 or ASC 825, the hybrid financial instrument cannot be
designated as a hedging instrument under ASC 815-20. Furthermore, the
documentation and disclosure requirements related to the fair value election
in ASC 815-15 are the same as those related to the fair value option in ASC
825-10.
Since the fair value election under ASC 815-15 applies to a narrower
population of items than does the fair value option under ASC 825, entities
can effectively disregard the fair value election guidance in ASC
815-15-25-4. While ASC 815-15 requires an entity to first determine that a
hybrid financial instrument contains an embedded derivative for which
bifurcation would otherwise be required under ASC 815-15, entities can
bypass this assessment because — regardless of whether such bifurcation is
required — the hybrid financial instruments that are eligible for the fair
value election in ASC 815-15 are also eligible for the fair value option in
ASC 825-10 (and the fair value option in ASC 825 can be elected regardless
of whether an entity has identified an embedded derivative for which
bifurcation would otherwise be required). In practice, an entity may elect
to apply the fair value option simply to avoid having to separately value an
embedded derivative if the entity expects it to be easier to determine the
fair value of the hybrid contract as a whole.
The disclosure requirements applicable to a hybrid financial instrument for
which the fair value election is made under ASC 815-15 are consistent with
those in ASC 825-10. Regardless of whether fair value accounting is elected under ASC 815-15 or ASC 825-10, an entity is subject to the applicable incremental disclosure requirements for (1) derivatives in ASC 815 and (2) items for which the fair value option has been elected in ASC 825-10. We believe that the guidance on fair value elections in ASC 815-15 (which was derived from FASB Statement 155) was retained in U.S. GAAP because that guidance was available (and may have been used) before the effective date of FASB Statement 159 (codified in ASC 825). Thus, entities may still have
hybrid financial instruments that are being recognized at fair value in
their entirety in accordance with ASC 815-15 because those instruments were
issued before the effective date of the fair value option guidance in ASC
825-10.
4.4.6.2 Measurement
ASC 815-15
30-1 An
entity shall measure both of the following initially
at fair value:
-
A hybrid financial instrument that under paragraph 815-15-25-1 would be required to be separated into a host contract and a derivative instrument that an entity irrevocably elects to initially and subsequently measure in its entirety at fair value (with changes in fair value recognized in earnings) . . .
35-1 If an
entity irrevocably elected to initially and
subsequently measure a hybrid financial instrument
in its entirety at fair value, changes in fair value
for that hybrid financial instrument shall be
recognized in earnings. Paragraph 815-20-25-71(a)(3)
states that the entire contract shall not be
designated as a hedging instrument pursuant to
Subtopic 815-20.
If an entity elects the fair value option in ASC 815-15 for
a hybrid financial instrument, no embedded feature should be separated as a
derivative (see Section
4.3.3). The accounting for the hybrid financial instrument is
the same as if the fair value option in ASC 825-10 had been applied (see
Chapter 12 of Deloitte’s Roadmap
Fair Value
Measurements and Disclosures (Including the Fair Value
Option)).
4.4.6.3 Presentation and Disclosure
For guidance on the presentation and disclosure of embedded derivatives, see
Chapter
7.
Footnotes
2
For more information about
Instrument C, see remarks of then
SEC Professional Accounting Fellow Robert
Comerford at the 2003 AICPA Conference on Current
SEC Developments.
3
If a debt instrument has been refinanced or modified
in such a way that it is substantially different from the original
instrument (i.e., an extinguishment of the original instrument), a
remeasurement under ASC 825 has occurred and the fair value option
could be elected (or no longer applied if it was previously
elected). See ASC 825-10-25-5 for specific examples. A modification
of a debt instrument that is not an extinguishment would not be
considered a remeasurement event. See Section 12.3.2.2.4 of
Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the
Fair Value Option).
Chapter 5 — Common Embedded Features Unique to Debt Host Contracts
Chapter 5 — Common Embedded Features Unique to Debt Host Contracts
5.1 Overview
As previously discussed in Chapter 4, ASC 815-15 outlines specific criteria
that an entity must consider when determining whether an embedded feature should be
bifurcated from its host contract. This chapter includes practical applications of the
guidance in ASC 815-15 to embedded features that are commonly found in and unique to
debt host contracts. See also Chapter
6 for discussion of embedded features that are commonly found in other
types of contracts (including debt contracts).
5.2 Features Related to an Interest Rate Embedded in a Debt Host
5.2.1 Background
This section discusses the analysis of whether an embedded feature that could
adjust the payments on a debt host contract that is based solely on an interest
rate or interest rate index should be separated as a derivative. Examples of
contractual provisions in debt contracts that should be evaluated under the
guidance discussed in this section include:
- Interest payments that are leveraged on the basis of market interest rates (e.g., the contractual interest rate is a multiple of a specified interest rate).
- Interest payments that move inversely with market interest rates (e.g., when market interest rates increase, the contractual interest rate decreases).
- Interest payments that are based on a tenor of a specified interest rate that is different from the tenor of the interest payments (e.g., a constant maturity yield).
- Choose-your-rate options (e.g., the debtor can elect to switch the basis of future variable- interest-rate payments to a different specified interest rate).
- Caps, floors, or collars on interest payments indexed to a market interest rate.
- Interest rate adjustments that are contingent on the level of interest rates.
- Certain put and call options that are not otherwise required to be viewed as not clearly and closely related to the debt host contract.
This section does not address features that are contingent on,
or indexed to, underlyings other than an interest rate or interest rate index.
Similarly, this section also does not address features that are indexed to both
interest rates and other underlyings.
For guidance on the evaluation of features that are indexed to underlyings other
than an interest rate or interest rate index, see, for example, Sections 5.3 (credit-sensitive payments),
5.4 (inflation-indexed payments),
6.2.2.4 (equity-indexed payments), 5.6 (foreign currency features), 6.8 (commodity-indexed payments), 6.9 (revenue-indexed payments), and 6.10 (other payments contingent on underlyings
other than interest rates, credit risk, or inflation).
5.2.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of an embedded
feature that is based solely on an interest rate or interest rate index and could
adjust the cash flows of 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 entity must evaluate whether an interest-related feature
is clearly and closely related to a debt host in accordance
with the negative-yield test and the double-double test (ASC
815-15-25-26).
|
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.
From the holder’s perspective, if a loan or debt security is
remeasured at fair value, with changes in fair value
recorded in earnings, any derivative embedded in the
interest would not need to be accounted for separately since
the accounting for the interest would already be the same as
that of a freestanding derivative.
|
Meets the definition of a derivative (see Section
4.3.4)
|
Yes
|
An interest-rate-related feature that adjusts the payments of
a debt host contract meets the definition of a derivative.
|
Meets a scope exception (see Chapter 2 and Section
4.3.5)
|
No
|
No scope exception is available for features that are based
solely on an interest rate or an interest rate index.
|
As shown in the table above, an entity’s determination of whether it
must bifurcate as a derivative an embedded feature that is based solely on an
interest rate or interest rate index and could adjust the payments of a debt host
contract tends to focus on whether the feature is considered clearly and closely
related to the debt host contract unless the entity is remeasuring the instrument at
fair value on a recurring basis through earnings. Typically, such features meet the
definition of a derivative and are not exempt from derivative accounting.
5.2.3 Clearly-and-Closely-Related Analysis
5.2.3.1 General
ASC 815-15
25-26 For
purposes of applying the provisions of paragraph
815-15-25-1, an embedded derivative in which the only
underlying is an interest rate or interest rate index
(such as an interest rate cap or an interest rate
collar) that alters net interest payments that otherwise
would be paid or received on an interest-bearing host
contract that is considered a debt instrument is
considered to be clearly and closely related to the host
contract unless either of the following conditions
exists:
- The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment (that is, the embedded derivative contains a provision that permits any possibility whatsoever that the investor’s [the holder’s or the creditor’s] undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms).
- The embedded derivative meets
both of the following conditions:
- There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract (that is, the embedded derivative contains a provision that could under any possibility whatsoever at least double the investor’s initial rate of return on the host contract).
- For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed in (b)(1)), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.
25-27 Even
though the conditions in (a) and (b) in the preceding
paragraph focus on the investor’s rate of return and the
investor’s recovery of its investment, the existence of
either of those conditions would result in the embedded
derivative not being considered clearly and closely
related to the host contract by both parties to the
hybrid instrument. Because the existence of those
conditions is assessed at the date that the hybrid
instrument is acquired (or incurred) by the reporting
entity, the acquirer of a hybrid instrument in the
secondary market could potentially reach a different
conclusion than could the issuer of the hybrid
instrument due to applying the conditions in the
preceding paragraph at different points in time.
25-28 An
embedded derivative that alters net interest payments
based on changes in a stock price index (or another
non-interest-rate index) is not addressed in paragraph
815-15-25-26.
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.
There are two conditions in ASC 815-15-25-26: one that focuses on the investor’s
recovery of its investment and one that focuses on the investor’s rate of
return. If either of these conditions is met, neither party to the hybrid
instrument would consider the embedded derivative feature clearly and closely
related to the host contract.
ASC 815-15-25-26 indicates that when an entity assesses whether it meets these
conditions, it should not consider the likelihood that a condition will be
satisfied — the condition is met if there is any possibility whatsoever that it
will be met.
5.2.3.2 Features That Are Indexed to Both Interest Rates and Other Underlyings
Because ASC 815-15-25-26 only applies to embedded features “in which the only
underlying is an interest rate or interest rate index,” it does not apply to
features that are indexed to, or contingent on, something other than an interest
rate or an interest rate index, including features that are indexed to both an
interest rate or interest rate index and other underlyings. An embedded put,
call, or other redemption feature whose exercise is contingent on the occurrence
or nonoccurrence of a specified uncertain, future event (e.g., an IPO or a
change in control) would always have a second underlying (the occurrence or
nonoccurrence of the specified event). Therefore, the redemption feature would
only be subject to evaluation under ASC 815-15-25-26 if the event is solely
related to an interest rate or an interest rate index (e.g., an embedded call
option that may only be exercised when SOFR is at or above 5 percent).
Although an embedded feature that has a payoff that is indexed to both interest
rates and another underlying (e.g., an event of default, a stock price,
commodity price, or the entity’s stock market capitalization) is not subject to
an evaluation under ASC 815-15-25-26, such a feature would not be considered
clearly and closely related to a debt host contract unless either (1) the other
underlying is based on the issuer’s credit risk (see Section 5.3) or inflation (see Section 5.4) or (2) the feature is a contingent redemption
feature that otherwise does not have to be separated under the guidance on such
features (see Section 6.4.2).
5.2.3.3 Negative-Yield Test
Under the negative-yield test (i.e., ASC 815-15-25-26(a)), an embedded interest
rate feature is not clearly and closely related to its debt host contract if it
could contractually cause the debt to be settled in such a way that the investor
would not recover substantially all of its initial recorded investment. In other
words, this test might be passed if it is contractually possible that the
creditor could be forced to accept a negative yield on its investment.
The debtor performs the negative-yield test as of the date on which it initially
recognizes the debt and does not subsequently reassess whether the test is
passed. The investor (or creditor) performs the test 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. Like the debtor, the
investor would not perform subsequent reassessment. It is possible that the
investor’s application of the negative-yield test would produce a different
result from the debtor’s initial evaluation 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.
Example 5-1
Bond With Leverage Feature
Company X invests in a $10 million 10-year bond that pays
a fixed rate of 6 percent for the first two years and
then pays a variable rate calculated as 14 percent minus
the product of 2.5 times three-month SOFR, without a
floor, for the remaining term of the bond.
Company X makes this investment as part of the initial
issuance of the bond and must perform the negative-yield
test as of the initial recognition date, the same date
on which the bond issuer performs the test. Company X
and the issuer should reach the same conclusion when
applying the negative-yield test.
If three-month SOFR were to increase significantly, the
bond might have a negative return, which would
effectively erode the bond’s principal. Because there is
a possibility that X may not recover substantially all
of its initial investment, the negative yield test is
passed. Company X and the bond issuer should, therefore,
separately account for the embedded interest rate
derivative unless the entire hybrid financial instrument
is recognized at fair value, with changes in fair value
recognized in earnings.
In practice, the phrase “substantially all” in ASC 815-15-25-26(a) is interpreted
to mean at least 90 percent of the original investment. The negative-yield test
is performed on an undiscounted basis. If, at inception, there is any
contractual possibility whatsoever that the undiscounted contractual net cash
flows received by the creditor over the life of the instrument will not be at
least 90 percent of the investment recorded by the investor at inception, the
negative-yield test is passed and the entity would consider the feature not to
be clearly and closely related to the debt host. Otherwise, an embedded feature
that is based only on an interest rate or interest rate index would be
considered clearly and closely related to its host provided that it does not
pass the double-double test (ASC 815-15-25-26(b); see Section
5.2.3.4).
ASC 815-15
25-29 The
condition in paragraph 815-15-25-26(a) applies only to
those situations in which the investor (creditor) could
be forced by the terms of a hybrid instrument to accept
settlement at an amount that causes the investor not to
recover substantially all of its initial recorded
investment. That condition does not apply to a situation
in which the terms of a hybrid instrument permit, but do
not require, the investor to settle the hybrid
instrument in a manner that causes it not to recover
substantially all of its initial recorded investment,
provided that the issuer does not have the contractual
right to demand a settlement that causes the investor
not to recover substantially all of its initial net
investment.
If scenarios exist in which the investor contractually would not recover
substantially all of its initially recorded investment but the creditor could
not be forced to accept such a settlement or could prevent such a scenario from
occurring, the negative-yield test is not passed. The negative-yield test only
applies to scenarios in which the creditor could be forced to accept a
settlement under which it would not recover substantially all of its initial
recorded investment. If the creditor has a right, but not an obligation, to
settle the debt at an amount that is less than substantially all of its
initially recorded investment (e.g., an embedded put option held by the creditor
that has an exercise price at a significant discount to the initial investment),
the negative-yield test is not passed.
Further, the negative-yield test does not reflect the risk that the debtor might
breach the contract (i.e., the test is not met merely because of the risk that
the debtor may default on its obligation to repay the debt). The negative-yield
test only applies to scenarios in which the creditor contractually is at risk of
not recovering substantially all of its initial recorded investment.
ASC 815-15
Example 10: Interest-Rate-Related Underlyings —
Recovering Substantially All of an Initial
Recorded Investment
Case A: Note A
55-130 If an
investor in a 10-year note has the contingent option at
the end of Year 2 to put it back to the issuer at its
then fair value (based on its original 10-year term),
the condition in paragraph 815-15-25-26(a) would not be
met even though the note’s fair value could have
declined so much that, by exercising the option, the
investor ends up not recovering substantially all of its
initial recorded investment. See paragraph
815-15-25-29.
Case B: Note B
55-131 An
investor purchased from an A-rated issuer for $10
million a structured note with a $10 million principal,
a 9.5 percent interest coupon, and a term of 10 years at
a time when the current market rate for 10-year A-rated
debt is 7 percent. Assume that the terms of the note
require that, at the beginning of the third year of its
term, the principal on the note be reduced to $7.1
million and the coupon interest rate be reduced to zero
for the remaining term to maturity if interest rates for
A-rated debt have increased to at least 8 percent by
that date. That structured note would meet the condition
in paragraph 815-15-25-26(a) for both the issuer and the
investor because the investor could be forced to accept
settlement that causes the investor not to recover
substantially all of its initial recorded investment.
That is, if increases in the interest rate for A-rated
debt trigger the modification of terms, the investor
would receive only $9 million, comprising $1.9 million
in interest payments for the first 2 years and $7.1
million in principal repayment, thus not recovering
substantially all of its $10 million initial net
investment.
Case C: Note C
55-132 The
investor purchases for $10,000,000 a structured note
with a face amount of $10,000,000, a coupon of 4.9
percent, and a term of 10 years. The current market rate
for 10-year debt is 7 percent given the A credit quality
of the issuer. The terms of the structured note require
that if the interest rate for A-rated debt has increased
to at least 10 percent at the end of 2 years, the coupon
on the note be reduced to zero, and the investor
purchase from the issuer for $10,000,000 an additional
note with a face amount of $10,000,000, a zero coupon,
and a term of 3.5 years.
55-133 The
structured note contains an embedded derivative that
shall be accounted for separately unless a fair value
election is made pursuant to paragraph 815-15-25-4.
55-134 The
requirement that, if interest rates increase and the
embedded derivative is triggered, the investor purchase
the second $10,000,000 note for an amount in excess of
its fair value (which is about $7,100,000 based on a 10
percent interest rate) generates a result that is
economically equivalent to requiring the investor to
make a cash payment to the issuer for the amount of the
excess. As a result, the cash flows on the original
structured note and the excess purchase price on the
second note shall be considered in concert. The cash
inflows ($10,000,000 principal and $1,780,000 interest)
that will be received by the investor on the original
note shall be reduced by the amount ($2,900,000) by
which the purchase price of the second note is in excess
of its fair value, resulting in a net cash inflow
($8,880,000) that is not substantially all of the
investor’s initial net investment on the original
note.
55-135 As
demonstrated by this Case, if an embedded derivative
requires an asset to be purchased for an amount that
exceeds its fair value, the amount of the excess — and
not the cash flows related to the purchased asset —
shall be considered when analyzing whether the hybrid
instrument can contractually be settled in such a way
that the investor would not recover substantially all of
its initial recorded investment under paragraph
815-15-25-26(a). Whether that purchased asset is a
financial asset or a nonfinancial asset (such as gold)
is not relevant to the treatment of the excess purchase
price. It is noted that requiring the investor to make a
cash payment to the issuer is also economically
equivalent to reducing the principal on the note.
55-136 The
note described could have been structured to include
terms requiring that the principal of the note be
substantially reduced and the coupon reduced to zero if
the interest rate for A-rated debt increased to at least
10 percent at the end of 2 years. That alternative
structure would clearly have required that the embedded
derivative be accounted for separately, because that
embedded derivative’s existence would have resulted in
the possibility that the hybrid instrument could
contractually be settled in such a way that the investor
would not recover substantially all of its initial
recorded investment.
Example 5-2
Evaluation of Interest Rate Swaps Included in
Securitization Vehicles
A securitization vehicle (i.e., an SPE) holds prepayable
fixed-rate mortgage loans with a principal amount of
$100,000 and issues variable-rate notes (beneficial
interests) with a principal amount of $100,000 to
investors. Concurrently with issuing its beneficial
interests, the SPE enters into a pay-fixed,
receive-variable interest rate swap with a third party.
The notional amount of the swap declines according to a
planned amortization schedule to approximate prepayment
forecasts for the underlying loans as of the
securitization date. A good-faith estimate was used to
develop the planned amortization schedule; this estimate
was reasonable given the facts and circumstances that
existed at hedge inception.
To assess the negative-yield test in ASC 815-15-25-26(a),
a holder of a variable-rate note must consider whether
the note can contractually be settled in such a way that
the holder would not recover substantially all of its
initial recorded investment in the note. In doing so, it
must consider all possible interest rate scenarios, even
those that are considered remote. In this example, an
unexpected decline in interest rates could cause the
fixed-rate loans held by the SPE to be prepaid at a
faster rate than had been expected as of the
securitization date. Because the notional amount of the
interest rate swap amortizes according to the original
prepayment expectations, the unexpected loan prepayments
could cause the notional amount of the swap to exceed
the outstanding principal amount of the underlying
loans.
If, for example, the swap contract requires the SPE to
make net payments to the swap counterparty because of a
decline in interest rates, the cash flows generated by
fixed-rate loans remaining in the SPE may not be
sufficient for the SPE to make payments to the
counterparty and pay off the principal on the
outstanding notes. In this scenario, it is possible that
the investor would not recover substantially all of its
initial recorded investment in its notes; accordingly,
the notes would pass the negative-yield test and the
holder of the variable-rate notes would conclude that
the notes contain an embedded derivative that is not
clearly and closely related to the host.
The holder then would have to assess whether the embedded
derivative satisfies the remaining conditions of ASC
815-15-25-1 to determine whether the embedded derivative
needs to be bifurcated from its host.
5.2.3.4 Double-Double Test
Under the double-double test (i.e., ASC 815-15-25-26(b)), an embedded interest
rate feature is not clearly and closely related to its debt host contract if
there is a potential scenario in which the investor could achieve a rate of
return on the host contract that at least doubles its initial rate of return and
is twice what would otherwise be the market return.
Both the debtor and the investor (or creditor) evaluate whether the double-double
test is passed as of the date on which the instrument is initially recognized.
Neither the debtor nor the investor subsequently reassesses whether the test is
passed. If the investor purchases the debt in a secondary market, it performs
the double-double test as of the date it recognized the debt investment. The
investor’s application of this test could produce a different result from that
of the debtor if the investor purchased the investment in a secondary market and
the market conditions or terms at the time of the secondary purchase have
changed from the time of initial issuance.
The double-double test is performed in two steps:
- Step 1 — The entity determines whether there is a possible future interest rate scenario, no matter how remote, in which the embedded feature would at least double the investor’s initial rate of return on the host contract. In making this assessment, the entity must differentiate between the return on the host contract and the return on the hybrid instrument. The initial rate of return on the host contract excludes the effects of the embedded feature. If no such scenario exists, the embedded feature would be considered clearly and closely related to its host provided that it does not pass the negative-yield test (ASC 815-15-25-26(a)). If any such scenario exists, the entity must proceed to step 2 below.
- Step 2 — The entity determines whether, for any of the scenarios identified in the first step for which the investor’s initial rate of return on the host contract would be doubled, the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception. If such a high return is possible, the embedded feature would not be considered clearly and closely related to its host contract. If such a high return is not possible for a feature that is based solely on an interest rate or interest rate index and the embedded feature also does not pass the negative-yield test (ASC 815-15-25-26(a)), the embedded feature is considered clearly and closely related to the host contract.
Example 5-3
Debt With Interest Step-Up Feature
Company A invests in 30-year variable-rate debt issued by
Company B. The debt is indexed to the three-month SOFR
rate plus 4 percent. As of the date of issuance, the
three-month SOFR rate was 2 percent. The debt’s terms
also specify that if the three-month SOFR rate increases
to 5 percent, the debt issuer is required to pay 23
percent for the remaining term of the bonds.
Company A makes its investment as part of the initial
issuance of B’s variable-rate debt. Accordingly, both A
and B would perform the double-double test as of the
same date and should reach the same conclusion.
If B were to issue 30-year variable-rate debt without any
embedded derivatives (i.e., the interest rate reset
feature), it would pay a coupon of three-month SOFR plus
6 percent. Consequently, the initial rate of return on
the host contract is 8 percent (three-month SOFR of 2
percent plus 6 percent). Company A must determine
whether the embedded derivative could at least double
its initial rate of return on the host contract, which
was 8 percent as of the issuance date, in any of the
possible interest rate environments. When three-month
SOFR increases to 5 percent, the 23 percent interest
rate feature more than doubles the initial rate of
return of 8 percent on the host contract; therefore,
step 1 of the double-double test is satisfied.
To apply step 2 of the double-double test, A must
determine whether, for any of the possible interest rate
scenarios under which its initial rate of return on the
host contract would be doubled (i.e., when three-month
SOFR is at 5 percent or higher), the embedded derivative
would at the same time result in a rate of return that
is at least twice what otherwise would be the
then-current market return on a contract with the same
terms as the host contract. When three-month SOFR
increases to 5 percent, the rate of return on a contract
with the same terms as the host contract (and involving
a debtor with a credit quality similar to B’s credit
quality at debt inception) would be 11 percent
(three-month SOFR of 5 percent plus 6 percent).
Therefore, step 2 of the double-double test is also
satisfied because when three-month SOFR increases to 5
percent, the 23 percent return generated by the embedded
derivative feature in the debt is more than twice the 11
percent return (three-month SOFR of 5 percent plus 6
percent) on the contract with the same terms as the host
contract.
Both A and B would be required to account for the
embedded derivative separately unless the entire hybrid
financial instrument is recognized at fair value, with
changes in fair value recognized in earnings. Note that
ASC 815-15-25-26 indicates that when an entity assesses
whether it meets one of the conditions, it should not
consider the probability that the condition will be
satisfied; the condition should be considered satisfied
if there is any possibility whatsoever that the
condition will be met. Therefore, the probability that
the three-month SOFR rate will increase to 5 percent or
higher is not relevant to the analysis of whether the
condition is met. However, an entity should consider
such probability when valuing any bifurcated embedded
derivative.
ASC 815-15
25-37 The
conditions in paragraph 815-15-25-26(b) do 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 (the issuer or the borrower). This
guidance does not affect the application of the
condition in paragraph 815-15-25-26(a) or the
application of paragraphs 815-15-25-41 through 25-43. In
addition, this guidance does not apply to other embedded
derivative features that may be present in the same
hybrid instrument.
25-38 The
conditions in paragraph 815-15-25-26(b) apply only to
situations that meet the two conditions specified in
paragraph 815-15-25-26(b)(1) through (b)(2) and for
which the investor has the unilateral ability to obtain
the right to receive the high rate of return specified
in those paragraphs. If the embedded derivative is an
option rather than a forward contract, it is important
to analyze whether the investor is the holder of that
option. For an embedded call option, the issuer or
borrower (and not the investor) is the holder, and thus
only the issuer (borrower) can exercise the option.
Consequently, the investor does not have the unilateral
ability to obtain the right to receive the high rate of
return, which is contingent on the issuer’s exercise of
the embedded call option.
If scenarios exist in which the investor could double its initial return but the
debtor could prevent any such scenarios from occurring, the double-double test
does not apply. For example, the double-double test does not apply if the debtor
has a right, but not an obligation, to settle the debt at an amount that would
pass the double-double test (e.g., an embedded call option held by the debtor
that has an exercise price that potentially could double the investor’s initial
return). The double-double test is passed only if scenarios exist in which the
debtor contractually could not prevent a settlement that would pass the
double-double test. ASC 815-15-55-25 (below) contains six examples that
illustrate this concept.
ASC 815-15
55-25
Application of the guidance in paragraphs 815-15-25-37
through 25-39 to specific debt instruments is provided
in the following table.
Instrument
|
Paragraph 815-15-25-26(b) Applicable to the
Embedded Call Option?
|
Comments
|
---|---|---|
1. An unsecured commercial loan that includes a
prepayment option that permits the loan to be
prepaid by the borrower at a fixed amount at any
time at a specified premium over the initial
principal amount of the loan.
|
No.
|
The commercial loan is prepayable only at the
option of the borrower.
|
2. A fixed-rate debt instrument issued at a
discount that is callable at par value at any time
during its 10-year term.
|
No.
|
The fixed-rate debt instrument is callable at
par value only by the issuer.
|
3. A fixed-rate 10-year bond that contains a
call option that permits the issuer to prepay the
bond at any time after issuance by paying the
investor an amount equal to all the future
contractual cash flows discounted at the
then-current Treasury rate plus 45 basis points.
The spread over the Treasury rate for the borrower
at the issuance of the bond was 300 basis points.
|
No.
|
The fixed-rate 10-year bond is callable only at
the option of the issuer.
|
4. A 5-year debt instrument issued at par that
has a quarterly coupon equal to 15 percent minus 3
times 3-month LIBOR and that includes a call
provision that allows the issuer to call the debt
at any time at a specified premium over par.
|
No.
|
The instrument is callable only by the issuer,
so the embedded call option feature will not be
subject to the conditions in paragraph
815-15-25-26(b). However, the conditions in the
paragraph are still applicable to the levered
index feature of the debt.
|
5. A fixed rate debt instrument is issued at
par and is callable at any time during its 10-year
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).
|
No.
|
The instrument is callable only by the issuer,
so the embedded call option feature will not be
subject to the conditions in paragraph
815-15-25-26(b). However, the embedded call option
is not considered clearly and closely related to
the debt host contract because the payoff is based
on an equity price.
|
6. A mortgage-backed security is issued,
whereby cash flows associated with principal
payments (including full or partial prepayments
and related penalties) received on the related
mortgage loans are passed through to the
mortgage-backed security investors.
|
Not applicable (see comments).
|
Although the related mortgage loans are
prepayable, and thus each contain a separate
embedded call option, the mortgage-backed security
itself does not contain an embedded call option.
While the mortgage-backed security investor is
subject to prepayment risk, the mortgage-backed
security issuer has the obligation (not the
option) to pass through cash flows from the
related mortgage loans to the mortgage-backed
security investors. Therefore, mortgage-backed
securities are not within the scope of this
guidance. Paragraphs 815-15-25-33 through 25-36
address the application of paragraph
815-15-25-26(b) to securitized interests in
prepayable financial assets.
|
5.2.3.5 Interest Rate Caps, Floors, and Collars
ASC 815-15
25-32 Floors
or caps (or collars, which are combinations of caps and
floors) on interest rates and the interest rate on a
debt instrument are considered to be clearly and closely
related unless the conditions in either paragraph
815-15-25-26(a) or 815-15-25-26(b) are met, in which
circumstance the floors or the caps are not considered
to be clearly and closely related.
Caps, floors, or collars on floating-rate interest payments are considered
clearly and closely related to a debt host contract unless either the
negative-yield test or the double-double test (ASC 815-15-25-26) is passed.
Example 5-4
Debt With Embedded Floor
Company A issues five-year variable-rate debt to the
public that is indexed to the SOFR rate (SOFR plus 1
percent). SOFR is currently 6 percent. The investors
required that A pay not less than 5 percent at any time
during the term of the debt. The agreement that A will
not pay an interest rate less than 5 percent on its
variable-rate debt represents a floor. If A had issued
five-year variable-rate debt without a floor, it would
have paid SOFR plus 2 percent.
The floor would not pass the negative-yield test (ASC
815-15-25-26(a)) because it could not result in a
failure of the investor to recover substantially all of
its initial investment. In addition, the floor would not
pass the double-double test (ASC-815-25-26(b)) because
it could not result in a rate of return that is more
than double the initial rate of return of 8 percent
(SOFR at inception plus 2 percent). The floor, when
in-the-money, will only result in a rate of 5
percent.
Example 5-5
Debt With Embedded Cap
On January 1, 20X1, Company X purchases a bond at par
that pays SOFR. The bond also incorporates an interest
rate cap provision under which if SOFR equals or exceeds
8 percent as of any interest rate reset date, X will
receive a return of 10 percent. On the date on which X
purchased the bond, it also could have purchased at par
a variable-rate bond not containing a cap that pays SOFR
minus 1 percent from a debtor that has the same credit
quality as the issuer of X’s bond. As of January 1,
20X1, SOFR is 5 percent.
Since the bond containing the cap cannot contractually be
settled such that X would not recover substantially all
of its initial recorded investment in the bond, the
negative-yield test in ASC 815-15-25-26(a) is not
passed. To perform the first step of the double-double
test (ASC 815-15-25-26(b)), X must determine whether
there are any interest rate scenarios, no matter how
remote, under which the embedded derivative (the cap)
would at least double its initial rate of return on the
host contract. This analysis is summarized in the
following table:
A
SOFR Interest Rate Range
|
B
Return Reflecting the Effect of Cap
|
C
Initial Rate of Return on Host (SOFR Minus
1%)
|
D
Initial Rate of Return on Host Doubled
|
Is the ASC 815-15-25-26(b)(1) Test Met — Is B >
D?
|
---|---|---|---|---|
0–7.99%
|
0–7.99%
|
4%
|
8%
|
No
|
8% and up
|
10%
|
4%
|
8%
|
Yes
|
Since the first step suggests that there is a possible
scenario in which X could double its initial rate of
return on the host contract, X must perform the second
step in ASC 815-15-25-26(b) to determine whether the
embedded cap is clearly and closely related to the debt
host contract. For this test, X must determine, for any
of the possible interest rate scenarios identified above
under which X’s initial rate of return on the host
contract would be doubled, whether the embedded cap
would simultaneously result in a rate of return that is
at least twice what otherwise would be the then-current
market return (under the relevant future interest rate
scenario) for a contract that (1) has the same terms as
the host contract and (2) involves a debtor with a
credit quality similar to the issuer’s credit quality at
inception. Company X’s analysis for this test can be
summarized as follows:
A
Interest Rate Scenario Identified in the ASC
815-15-25-26(b)(1) Test for Which the Cap Would at
Least Double the Investor’s Initial Rate of Return
on the Host Contract
|
B
Return Reflecting the Effect of the Cap Under
the Interest Rate Scenario in A
|
C
Current Market Rate for a Contract Having the
Same Terms as the Host Contract Under the Interest
Rate in A
(SOFR Minus 1%)
|
Is the ASC 815-15-25-26(b)(2) Test Met — Is B
at Least Twice C for Any Scenario?
|
---|---|---|---|
8% and up
|
10%
|
7% and up
|
No
|
Since the second step suggests that there is no possible
scenario in which the investor would achieve a rate of
return that is at least twice what otherwise would be
the then-current market return, the double-double test
in ASC 815-15-25-26(b) is not passed, and the embedded
cap is considered clearly and closely related to the
debt host contract.
Example 5-6
Debt With SOFR-Indexed Interest Rate
Adjustment
On January 1, 20X0, an entity issues a variable-rate debt
instrument at par, maturing on January 1, 20X5. The
interest rate is three-month SOFR plus 0.40 percent as
long as three-month SOFR remains at or above 6.00
percent. In periods in which three-month SOFR drops
below 6.00 percent, the interest rate on the debt is
calculated as follows: three-month SOFR plus 0.40
percent – [2 × (6.00% – 3-month SOFR)]. The following
table illustrates the interest rate on the debt under
certain conditions:
Three-Month SOFR
|
Interest Rate on Debt
|
---|---|
7.00%
|
7.40%
|
5.00%
|
3.40%
|
3.00%
|
(2.60%)
|
For the embedded derivative to be considered clearly and
closely related to the debt host, it must not be
contractually possible for the hybrid instrument to be
settled in such a way that the investor would not
recover substantially all of its initial recorded
investment. In this example, it is possible for the
investor in the debt to incur an unlimited negative
return, thus not recovering substantially all of its
original investment. Therefore, the negative-yield test
in ASC 815-15-25-26(a) is passed, and the embedded floor
would not be considered clearly and closely related to
the debt host.
By contrast, assume that the agreement contained a
provision that guaranteed a cumulative minimum rate of
return to the investor over the life of the debt. For
example, the agreement could contain a minimum interest
rate clause such that negative interest accrues if the
defined interest rate is less than zero; however, the
accrued negative interest could only be applied to (1)
future interest payments required under this debt or
(2) the principal amount only to the extent of interest
previously paid under the debt agreement, provided that
any accrued interest remains at the debt’s maturity. In
this scenario, the instrument could not contractually be
settled in such a way that the investor would not
recover substantially all of its initial recorded
investment. Therefore, the negative-yield test in ASC
815-15-25-26(a) would not be passed, and the leveraged
interest rate terms and floor would be considered
clearly and closely related to the debt (provided that
under ASC 815-15-25-26(b)’s double-double test, those
embedded features are clearly and closely related to the
debt host). A cap on a leveraged interest rate index
would be similarly analyzed under ASC 815-15-25-26
through 25-29.
5.2.3.6 Interest Rate Tenor Mismatch (Including Constant Maturity Rates)
The contractual interest rate of many debt securities is based on a reference
index. It is not uncommon for the contractual terms of some securities to
require the contractual interest rate to reset more frequently than the term of
the index the securities are referenced to. One example is a debt security whose
interest rate resets every six months to a 10-year index (i.e., a constant
maturity rate). Such an interest rate index should be evaluated under ASC
815-15-25-26.
Connecting the Dots
LIBOR, and other IBOR reference rates, are no longer
expected to exist as a result of reference rate reform. The Alternative
Reference Rate Committee1 has indicated that SOFR is the recommended replacement rate for
U.S. dollar LIBOR rates. As entities have been modifying contracts to
designate fallback language to determine the replacement rate upon
LIBOR’s cessation, and as entities have been issuing new contracts to
reference SOFR, questions have emerged regarding whether certain SOFR
conventions could create embedded derivatives that should be evaluated
for potential bifurcation. In a speech at the 2020 AICPA Conference on Current SEC
and PCAOB Developments, then SEC Professional Accounting Fellow Jillian
Pearce discussed a preclearance submission in which the SEC staff did
not object to a view that certain SOFR-based interest rate features did
not require bifurcation from a debt host contract. The preclearance
applied to the following four SOFR interest rate reset features:
- Term SOFR rates.
- Compounded SOFR in arrears rate.
- Compounded SOFR in advance rate.
- For adjustable-rate residential mortgages: average SOFR in-advance rate that resets every 6 months and resets 45 days before the beginning of the interest period on the basis of the trailing 30 or 90 days SOFR average.
According to Ms. Pearce, the SEC staff did not believe that it was
necessary to evaluate such features in the context of the guidance in
ASC 815-15-25-26; rather, “the SOFR interest rate reset features
evaluated in the consultation were terms of the host contract.”
We understand that the SEC staff reached this view partially because of
its belief that relief was needed for entities with such features during
the LIBOR to SOFR transition period as well as the general expectation
that SOFR markets will develop to include features similar to the
existing LIBOR features.
The outcome of this preclearance should not be analogized to any other
fact patterns or other features. Entities are encouraged to consult with
their accounting advisers if they believe that any of their debt
agreements contain the specific SOFR interest rate reset features
subject to the preclearance.
Example 5-7
Debt With Interest Rate Tenor Mismatch
Assume that a 30-year note has an initial yield of 4
percent and that the contractual interest rate resets
semiannually to a 10-year index interest rate plus 100
basis points rather than to the six-month rate. The
initial yield on a security that resets to the six-month
rate, but that otherwise has terms that are identical to
those of the 30-year note, is 3 percent.
Because the interest rate resets semiannually to a point
further out than the next reset date on the interest
rate curve (i.e., a 10-year rate versus a six-month
rate), there are possible future interest rate scenarios
under which the initial rate of return on the host
contract and the then-current market rate would be
doubled. The application of the double-double test (ASC
815-15-25-26(b)) is shown in the table below.
Step 1: Is there a possible interest rate
scenario (even though it may be remote) under
which the embedded derivative would at least
double the investor’s initial rate of return on
the host contract?
|
Yes. It is possible that the 10-year index rate
could be more than double the investor’s initial
rate of return on the host contract, which is 3
percent.
|
Step 2: For any of the possible interest rate
scenarios under which the investor’s initial rate
of return on the host contract would be doubled,
could the embedded derivative at the same time
result in a rate of return that is at least twice
what otherwise would be the then-current market
return (under the relevant future interest rate
scenario) for a contract that has the same terms
as the host contract and that involves a debtor
with a credit quality similar to the issuer’s
credit quality at inception?
|
Yes. It is possible that the 10-year index rate
could be more than double the six-month rate on
the same date; therefore, the embedded derivative
could result in a rate of return that is at least
twice the then-current market return for a
contract that has the same terms as the host
contract, which resets to the current six-month
rate. Note that it is irrelevant whether it is
probable that the 10-year rate will rise to more
than twice the six-month rate.
|
Because both conditions of the double-double test in ASC
815-15-25-26(b) are met, the embedded interest rate
index is not considered clearly and closely related to
the debt host of the 30-year note. If the instrument
contains a cap that is less than double the initial rate
of return on the host contract, however, the conditions
in ASC 815-15-25-26(b) would not be met.
5.2.3.7 Choose-Your-Rate Option
Variable-rate credit facilities often include an option for the debtor to change
the interest rate index that is used as the basis for calculating interest rate
payments on outstanding debt (e.g., an option to switch from one specified
interest rate to another specified interest rate). Such a feature is clearly and
closely related to its debt host contract unless the negative-yield test or the
double-double test (ASC 815-40-15-26) is passed.
5.2.3.8 Examples
ASC 815-15-55 contains additional illustrative examples of the application of ASC
815-15-25-26.
5.2.4 Derivative Analysis
The table below presents an analysis of whether an embedded feature
that is based solely on an interest rate or interest rate index and could adjust the
payments of a debt host contract 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
|
An embedded feature that could adjust the payments of a debt
host contract solely on the basis of an interest rate or
interest rate index typically has both an underlying (i.e.,
the interest rate or interest rate index) and a notional
amount (i.e., the amount on which the interest rate
adjustment is based, such as the debt’s outstanding amount)
or payment provision (e.g., a fixed cash payment contingent
on an interest rate or interest rate index).
|
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 interest-rate-related feature on a stand-alone
basis without the host contract). Generally, an embedded
feature that could adjust the cash flows of a debt host
contract solely on the basis of an interest rate or interest
rate index has an initial net investment that is smaller
than would be required for a direct investment that has the
same exposure to changes in interest rates (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)
|
Yes
|
An embedded feature that adjusts the payments of a debt host
contract solely on the basis of an interest rate or interest
rate index meets the net settlement condition (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, an embedded feature that is based
solely on an interest rate or interest rate index and could adjust the payments of a
debt host contract typically meets the definition of a derivative. Therefore, the
analysis of whether it 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 is remeasuring the debt at fair value on a recurring basis through
earnings.
Footnotes
1
The Alternative Reference Rates Committee (ARRC)
was formed by the Federal Reserve Board and the New York Fed to
guide the transition from LIBOR to SOFR.
5.3 Credit-Risk-Related Features Embedded in a Debt Host
5.3.1 Background
Examples of contractual provisions in debt contracts that could adjust payments
on the basis of a measure of credit risk include:
- A provision that requires the debtor to pay additional interest (e.g., 2 percent per annum) upon the debtor’s event of default.
- A feature that adjusts interest payments on the basis of a measure of the debtor’s creditworthiness (e.g., a table that specifies different margins over a specified interest rate on the basis of a measure of the debtor’s working capital).
- A feature that adjusts principal or interest payments on the basis of the credit risk of a third party.
This section does not address features that could accelerate the
repayment of the outstanding amount of the debt host contract in cash upon the
occurrence or nonoccurrence of a specified event such as an event of default.
Such features should be evaluated as contingent redemption features (see
Section
6.4).
5.3.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a
credit-risk-related feature 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
|
A credit-sensitive payment that is based solely on the
creditworthiness of the debtor is clearly and closely
related to a debt host. However, the creditworthiness of a
third party 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.
From the holder’s perspective, if a loan or debt security is
remeasured at fair value, with changes in fair value
recorded in earnings, any derivative embedded in the
interest would not need to be accounted for separately since
the accounting for the interest would already be the same as
that of a freestanding derivative.
|
Meets the definition of a derivative (see Section
4.3.4)
|
Yes
|
A credit-risk-related feature that adjusts the payments of a
debt host contract meets the definition of a derivative.
|
Meets a scope exception (see Chapter 2 and Section
4.3.5)
|
It depends
|
Typically, no specific scope exception is available for a
credit-risk-related feature that is based on the debtor’s
creditworthiness(see Section 4.3.5).
However, in some situations the scope exception for
financial guarantee contracts may apply (see
Section 2.3.4).
|
As shown in the table above, an entity’s determination of whether an embedded
credit-risk-related 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 is remeasuring the hybrid
instrument at fair value on a recurring basis through earnings. If the
credit-risk-related feature is based on the credit risk of a third party, the entity
should also evaluate whether the feature can be net settled (see Section
5.3.4) and whether it qualifies for the scope exception for financial
guarantee contracts (see Section 2.3.4).
5.3.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-46 The
creditworthiness of the debtor and the interest rate on a
debt instrument shall be considered to be clearly and
closely related. Thus, for debt instruments that have the
interest rate reset in the event of any of the following
conditions, the related embedded derivative shall not be
separated from the host contract:
- Default (such as violation of a credit-risk-related covenant)
- A change in the debtor’s published credit rating
- A change in the debtor’s creditworthiness indicated by a change in its spread over U.S. Treasury bonds.
25-47 If an
instrument incorporates a credit risk exposure that is
different from the risk exposure arising from the
creditworthiness of the obligor under that instrument, such
that the value of the instrument is affected by an event of
default or a change in creditworthiness of a third party
(that is, an entity that is not the obligor), then the
economic characteristics and risks of the embedded credit
derivative are not clearly and closely related to the
economic characteristics and risks of the host contract,
even though the obligor may own securities issued by that
third party. This guidance shall be applied to all other
arrangements that incorporate credit risk exposures that are
unrelated or only partially related to the creditworthiness
of the issuer of that instrument. This guidance does not
affect the accounting for a nonrecourse debt arrangement
(that is, a debt arrangement in which, in the event that the
debtor does not make the payments due under the loan, the
creditor has recourse solely to the specified property
pledged as collateral).
A credit-sensitive payment is considered clearly and closely related to a debt host
contract under ASC 815-15-25-46 and 25-47 if it is triggered by, and directionally
consistent with, a measure of the debtor’s creditworthiness, such as one or more of
the following:
- The debtor’s failure to pay amounts due on a timely basis (e.g., additional interest on late payments).
- The debtor’s failure to comply with credit-risk-related debt covenants (e.g., additional interest that becomes payable if there is a material adverse change in the debtor’s creditworthiness).
- A change in the debtor’s published credit rating (e.g., additional interest that becomes payable upon a credit rating downgrade).
- A change in observable interest rate spreads over a risk-free interest rate (e.g., U.S. Treasury rates) for debt instruments with similar credit risk (e.g., an interest rate that varies on the basis of observable credit spreads on identical or similar debt securities issued by the debtor or other similar debtors).
- A change in another measure of the debtor’s creditworthiness (e.g., a specified interest margin that varies on the basis of a measure of the debtor’s working capital).
However, a provision that requires an adjustment on the basis of the
creditworthiness of a third party (e.g., the third party’s default) is not clearly
and closely related to a debt host contract.
Debt contracts often contain provisions that require the debtor to pay additional
interest upon the occurrence of an “event of default.” To determine whether such a
provision is clearly and closely related to the debt host, the entity must evaluate
how the debt terms define an event of default. The table below discusses common
situations that may be described as events of default and whether such triggering
events would be considered clearly and closely related to a debt host.
Triggering Event
|
Clearly and Closely Related?
|
---|---|
Any representation or warranty made by the debtor is not
correct
|
Yes
|
The debtor’s failure to perform or comply with financial or
nonfinancial covenants
|
Yes, unless the covenants include items that do not affect
the issuer’s credit risk
|
The debtor’s bankruptcy or insolvency
|
Yes
|
Cross default on the debtor’s other indebtedness
|
Yes, unless the default on the other indebtedness arises from
events that are not credit-related
|
Invalidity or failure of debtor to maintain loan or
collateral documents
|
Yes
|
The debtor’s nonpayment of principal or interest when due
|
Yes
|
Judgments or orders against the debtor exceeding a specific
amount
|
Yes
|
Revocation of the debtor’s license or permit to perform
business operations that results in a material adverse
effect
|
Yes
|
Criminal events of the debtor
|
Yes
|
A change of control of the debtor
|
No
|
Key-person event
|
Depends on facts and circumstances
|
The debtor suffers a credit rating downgrade
|
Yes
|
An observable increase in the debtor’s current interest rate
spread over a risk-free interest rate
|
Yes
|
Example 5-8
Debt With Interest Rate Adjustment
Company ABC, which is rated BBB, issues $100 million in 8
percent fixed-rate bonds. The bonds include a provision that
requires the interest rate to reset to 10 percent if ABC’s
credit rating is downgraded to a single B at any time during
the term of the bonds. The embedded derivative that resets
the interest rate of the bonds is clearly and closely
related to the debt host because it is based on the issuer’s
credit rating.
However, if ABC’s bonds include a provision that requires the
interest rate to reset to 10 percent if Company XYZ’s (an
unrelated party’s) credit rating is downgraded to a single B
at any time during the term of the bonds, the reset feature
is not clearly and closely related to the debt host.
ASC 815-15
Case A: Credit-Linked Note
55-103 Entity A issues to an
investor a fixed-rate, 10-year, $10 million credit-linked
note that provides for periodic interest payments and the
repayment of principal at maturity. However, upon default of
a specified reference security (an Entity X subordinated
debt obligation) the redemption value of the note may be
zero or there may be some claim to the recovery value of the
reference security (depending on the terms of the specific
arrangement). Generally, the term reference security
refers to the security whose credit rating or default
determines the cash flows under a credit derivative.
Usually, the terms of credit-linked notes explicitly
reference Committee on Uniform Security Identification
Procedures (CUSIP) numbers of securities in the marketplace.
In an event of default of the specified reference security,
there is no recourse to the general credit of the obligor
(Entity A). In exchange for accepting the default risk of
the reference security, the note entitles the investor to an
enhanced yield. The transaction results in the investor
selling credit protection and Entity A buying credit
protection.
55-104 The
credit-linked note includes an embedded credit derivative.
The credit risk exposure of the reference security (Entity
X) and the risk exposure arising from the creditworthiness
of the obligor (Entity A) are not clearly and closely
related. Thus, the economic characteristics and risks of the
embedded derivative are not clearly and closely related to
the economic characteristics and risks of the debt host
contract and, accordingly, the criterion in paragraph
815-15-25-1(a) is met.
55-105
Paragraph 815-15-25-6 explains that the fair value election
for hybrid financial instruments that otherwise would
require bifurcation does not apply to hybrid financial
instruments that are described in paragraph 825-10-50-8,
which include insurance contracts as discussed in Section
944-20-15, other than financial guarantees and investment
contracts.
55-106
Consideration should be given to whether the embedded
derivative could possibly not be subject to this Topic as a
financial guarantee under paragraph 815-10-15-58 and, in
that circumstance, the embedded derivative would not warrant
bifurcation.
Case M: Credit-Sensitive Bond
55-200 A
credit-sensitive bond has a coupon rate of interest that
resets based on changes in the issuer’s credit rating.
55-201 A
credit-sensitive bond can be viewed as combining a
fixed-rate bond with a conditional exchange contract (or
option contract) that entitles the investor to a higher rate
of interest if the credit rating of the issuer declines.
Because the creditworthiness of the debtor and the interest
rate on a debt instrument are clearly and closely related,
the embedded derivative should not be separated from the
host contract.
Example 5-9
EBITDA-Indexed Rate Reset Provision
Company A issues term loans of $150 million, which pay a
floating rate of interest. The floating interest rate is
adjusted quarterly and is based on an interest rate index
plus a spread over the interest rate index. At each interest
repricing date, A may elect to choose bank prime or SOFR as
the interest rate index. The spread above the interest rate
index is based on A’s debt to EBITDA ratio at the end of the
most recent quarter.
As A pays down or issues debt and its operating income
increases or decreases from the previous period, the overall
interest rate payments fluctuate. The spread above the
interest rate index on A’s debt fluctuates on the basis of
A’s operating income and outstanding debt balance. The
economic characteristics of these terms may be determined to
be directly related to A’s creditworthiness and, in such
case, would be clearly and closely related to the debt
host.
If, however, it is determined that the terms were not
directly related to A’s creditworthiness, they would not be
considered clearly and closely related to the debt host, and
there may be an embedded derivative that should be accounted
for. For example, if the spread above the interest rate
index increased as EBITDA increased, the feature related to
EBITDA would not be directly related to the debtor’s
creditworthiness and, therefore, would not be considered to
be clearly and closely related to the debt host.
5.3.4 Derivative Analysis
The table below presents an analysis of whether a
credit-risk-related embedded feature that could adjust the payments on a debt host
contract 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 credit-risk-related feature that could adjust the payments
of a debt host contract generally has both an underlying
(e.g., an event of default or the issuer’s credit rating)
and a notional amount (i.e., the amount on which the
adjustment is based, such as the debt’s outstanding amount)
or payment provision (e.g., a fixed cash payment).
|
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 credit-risk-related feature on a stand-alone
basis without the host contract). Generally, a
credit-risk-related 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 credit
risk (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)
|
Yes
|
A credit-risk-related embedded feature that adjusts the
payments of a debt host contract meets the net settlement
condition (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 credit-risk-related embedded feature that could adjust
the payments of a debt host contract on the basis of the debtor’s creditworthiness
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
is remeasuring the hybrid instrument at fair value on a recurring basis through
earnings.
5.4 Features Indexed to Inflation in a Debt Host
5.4.1 Background
This section discusses the analysis of whether an inflation-indexed payment
feature embedded in a debt host contract should be separated as a derivative
(e.g., inflation-linked bonds). The discussion does not address features that
could accelerate the repayment of the outstanding amount of the debt in cash
upon the occurrence or nonoccurrence of a specified event (e.g., an acceleration
feature that is triggered by a specified measure of inflation). Such features
should be evaluated as contingent redemption features (see Section
4.4.4).
5.4.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of an
inflation-indexed payment feature 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 rate of inflation in the economic environment for the
currency in which the debt is denominated is clearly and
closely related to the debt host unless the feature is
leveraged (see Section 4.4.2.3). The
rate of inflation in other economic environments 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.
From the holder’s perspective, if a loan or debt security is
remeasured at fair value, with changes in fair value
recorded in earnings, any derivative embedded in the
interest would not need to be accounted for separately since
the accounting for the interest would already be the same as
that of a freestanding derivative.
|
Meets the definition of a derivative (see Section
4.3.4)
|
Yes
|
An inflation-indexed payment feature that adjusts the
payments of a debt host contract meets the definition of a
derivative (see Section 4.4.2.4).
|
Meets a scope exception (see Chapter 2 and Section
4.3.5)
|
No
|
No specific scope exception is available for
inflation-indexed payment features embedded in debt host
contracts (see Section 4.3.5).
|
As shown in the table above, an entity’s determination of whether an
inflation-indexed feature that could adjust the payments of a debt host contract
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
is remeasuring the hybrid instrument at fair value on a recurring basis through
earnings. Typically, such features meet the definition of a derivative and are not
exempt from the scope of derivative accounting.
5.4.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-50 The
interest rate and the rate of inflation in the economic
environment for the currency in which a debt instrument is
denominated shall be considered to be clearly and closely
related. Thus, nonleveraged inflation- indexed contracts
(debt instruments, capitalized lease obligations, pension
obligations, and so forth) shall not have the
inflation-related embedded derivative separated from the
host contract.
Under ASC 815-15-25-50, the indexation of principal or interest payments to an
inflation rate (e.g., U.S. CPI or U.K. retail price index) is considered clearly and
closely related to a debt host contract if (1) the inflation rate is appropriate for
the economic environment for the currency in which the debt is denominated and (2)
the feature is not leveraged (e.g., interest payments that are computed on the basis
of two times CPI would not be considered clearly and closely related to a debt host
contract). For example, payments indexed to an unleveraged measure of U.S. CPI would
be considered clearly and closely related to USD-denominated debt. Conversely, the
rate of inflation in a different economic environment (e.g., EUR-denominated debt
that has principal or interest payments indexed to U.S. CPI) is not clearly and
closely related to the debt host.
Example 5-10
Debt With Embedded Inflation Index Feature
A U.S. company issues USD-denominated bonds. On the basis of
an embedded inflation index, the bond issuer is required to
pay the change in the Mexican CPI every two years. The
embedded inflation-indexed derivative is not clearly and
closely related to the bond because it is not the rate of
inflation of the United States, the economic environment in
which the bond was issued. However, if the bond issuer was
required to pay the change in U.S. CPI every two years, the
embedded derivative would be clearly and closely related
and, therefore, would not need to be accounted for
separately.
ASC 815-15
Case N: Inflation Bond
55-202 An
inflation bond has a contractual principal amount that is
indexed to the inflation rate but cannot decrease below par;
the coupon rate is typically below that of traditional bonds
of similar maturity.
55-203 An
inflation bond can be viewed as a fixed-rate bond for which
a portion of the coupon interest rate has been exchanged for
a conditional exchange contract (or option contract) indexed
to the consumer price index, or other index of inflation in
the economic environment for the currency in which the bond
is denominated, that entitles the investor to payment of
additional principal based on increases in the referenced
index. Such rates of inflation and interest rates on the
debt instrument are considered to be clearly and closely
related. Therefore, the embedded derivative should not be
separated from the host contract.
5.4.4 Derivative Analysis
The table below presents an analysis of whether an inflation-indexed
feature that could adjust the cash flows of a debt host contract 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
|
An inflation-indexed payment feature that could adjust the
payments of a debt host contract has both an underlying
(i.e., the applicable measure of inflation, such as the
change in CPI) and a notional amount (i.e., the amount on
which the adjustment is based, such as the debt’s
outstanding amount) or payment provision (e.g., a fixed cash
payment).
|
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 inflation-indexed feature on a stand-alone basis
without the host contract). Generally, an inflation-indexed
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 inflation rate (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
|
A feature that adjusts the payments of a debt host contract
on the basis of an inflation index meets the net settlement
condition (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, an inflation-indexed feature embedded in a debt host
contract typically 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 is remeasuring the hybrid instrument at fair value on a recurring
basis through earnings.
5.5 Term Extension Features in a Debt Host
5.5.1 Background
Term extension features embedded in a debt host contract include those that give
either party the right to extend the debt’s remaining term or automatically
extend the term upon the occurrence of a specified event.
5.5.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a term extension
feature 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
|
A term extension feature is not clearly and closely related
to a debt host unless the interest rate is concurrently
reset to a current market rate and the debt initially did
not involve a significant discount.
|
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.
From the holder’s perspective, if a loan or debt security is
remeasured at fair value, with changes in fair value
recorded in earnings, any derivative embedded in the
interest would not need to be accounted for separately since
the accounting for the interest would already be the same as
that of a freestanding derivative.
|
Meets the definition of a derivative (see Section
4.3.4)
|
It depends
|
The evaluation of whether a term extension feature 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 Chapter 2 and Section
4.3.5)
|
Generally, yes
|
A term extension feature embedded in a debt host contract
often qualifies for the loan commitment scope exception.
However, this scope exception is not available if the term
extension option is held by the creditor.
|
As shown in the table above, a term extension feature in a debt host would not be
bifurcated if (1) the feature is considered clearly and closely related to the debt
host contract (see the next section), (2) the entity is remeasuring the hybrid
instrument at fair value on a recurring basis through earnings, (3) the feature does
not meet the definition of a derivative, or (4) the feature meets the scope
exception for loan commitments.
5.5.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-44 An embedded derivative
that either (a) unilaterally enables one party to extend
significantly the remaining term to maturity or (b)
automatically extends significantly the remaining term
triggered by specific events or conditions is not clearly
and closely related to the interest rate on a debt
instrument unless the interest rate is concurrently reset to
the approximate current market rate for the extended term
and the debt instrument initially involved no significant
discount. Thus, if there is no reset of interest rates, the
embedded derivative is not clearly and closely related to
the host contract. That is, a term-extending option cannot
be used to circumvent the restriction in paragraph
815-15-25-26 regarding the investor’s not recovering
substantially all of its initial recorded investment.
Under ASC 815-15-25-44, a term extension feature is clearly and closely related to a
debt host only if (1) the interest rate is adjusted to the approximate current
market rate of interest for the extended term at the time the term is extended and
(2) the debt did not initially involve a significant discount.
Example 5-11
Debt With Extension Option
Company XYZ issues five-year, variable-rate debt that pays
three-month SOFR plus 250 basis points on a quarterly basis.
At the end of five years, XYZ has an option to extend the
debt for another three years and, if the option is
exercised, XYZ will continue to pay three-month SOFR plus
250 basis points for the extended term.
Although the debt continues to vary on the basis of
three-month SOFR if the term of the debt is extended, the
interest rate does not reset to current market rates because
the credit spread is not adjusted. At the end of the
original five-year term, the current market rate for an
issuer with the creditworthiness of XYZ may be different
than three-month SOFR plus 250 basis points (e.g., the
current market rate for XYZ debt could be SOFR plus 750
basis points), even if the creditworthiness of XYZ has not
changed. Therefore, because XYZ has the option to extend the
maturity of the debt significantly and the interest rate in
its entirety does not reset to market, the term-extending
option is not clearly and closely related to the debt
host.
The analysis of whether a term extension feature is clearly and
closely related to a debt host is different from the analysis of whether an embedded
prepayment (or call) option is clearly and closely related to a debt host even
though economically such features may be similar.
Example 5-12
Bonds With Extension Options
Entity ABC issues two series of bonds that are publicly
traded. One bond has a five-year term and a 6 percent fixed
coupon rate and grants the bondholder an option to extend
the debt for another three years at a 6 percent fixed
interest rate. The second bond has an eight-year term and a
6 percent fixed coupon rate and grants the bondholder an
option to put the debt back to ABC at the end of five years.
Although these two bonds are economically similar, they are
analyzed differently under ASC 815. The first bond is
analyzed as a five-year debt host contract with an embedded
term extension feature; the second bond is analyzed as an
eight-year debt host contract with an embedded put
option.
The term-extending option in the first bond extends the maturity of the debt
significantly but does not reset the interest rate to a market rate. The
term-extending option, therefore, is not clearly and closely related to the debt
host and may need to be bifurcated from the host contract and accounted for
separately if it meets the other criteria in ASC 815-15-25-1. The embedded put
option in the second bond would not be evaluated under the guidance on term
extension options. Instead, it would be evaluated under the guidance on embedded put
options (see Section 6.4).
5.5.4 Derivative Analysis
The table below presents an analysis of whether a term extension
feature embedded in a debt host contract meets the definition of a derivative (see
Section 4.3.4). 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
|
A term extension feature in a debt host contract has both an
underlying (interest rates and, if applicable, the
occurrence or nonoccurrence of any exercise contingency) and
a notional amount (the principal amount subject to
extension) 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 term extension feature on a stand-alone basis
without the debt host contract). Generally, a term extension
feature has an initial net investment that is smaller than
would be required for a direct investment in the amount of
debt that is subject to the term extension (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
|
Typically, the entity would evaluate whether the debt
contract that will be extended is RCC (see below).
|
Generally, the analysis of whether an embedded term extension feature meets the
definition of a derivative focuses on whether the feature meets the net settlement
characteristic. If a term extension 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 depends on whether the instrument whose
maturity is being extended is RCC (e.g., publicly traded debt that may be sold in
increments that can be rapidly absorbed by the market without significantly
affecting the price). If the underlying debt is not RCC, the embedded term extension
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.
5.6 Foreign Currency in a Debt Host
5.6.1 Background
This section discusses the analysis of whether a feature whose value changes on
the basis of changes in one or more foreign currency exchange rates should be
separated from a debt host contract and accounted for as a derivative. For
example, some debt instruments contain an option to convert principal, interest
payments, or both at a fixed foreign currency exchange rate. Further, the terms
of some debt instruments (e.g., dual currency bonds) have principal and interest
payments denominated in different currencies.
This section does not apply to a feature that does not present an exposure to the
risk of changes in the exchange rate of foreign currency that is different from
the currency in which the debt is denominated, such as certain currency
conversion convenience clauses (see Section 5.6.5).
Further, it does not apply to debt merely by virtue of its denomination in a
currency that is different from the debtor’s functional currency unless the debt
contains one or more features that are denominated in a currency that is
different from that in which the debt was denominated (e.g., a foreign currency
option).
5.6.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a foreign
currency feature embedded in a debt host contract. 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 feature that presents an exposure to changes in the
exchange rate of foreign currency that is different from the
debt’s currency of denomination 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.
From the holder’s perspective, if a loan or debt security is
remeasured at fair value, with changes in fair value
recorded in earnings, any derivative embedded in the
interest would not need to be accounted for separately since
the accounting for the interest would already be the same as
that of a freestanding derivative.
|
Meets the definition of a derivative (see Section
4.3.4)
|
Yes
|
A feature that presents an exposure to changes in a foreign
currency exchange rate meets the definition of a
derivative.
|
Meets a scope exception (see Chapter 2 and Section
4.3.5)
|
It depends
|
The entity should evaluate whether the foreign currency
feature is exempt from derivative accounting under ASC
815-15-15-5.
|
As shown in the table above, an entity’s determination of whether a foreign currency
feature must be bifurcated from a debt host contract and accounted for as derivative
tends to focus on whether the feature meets a scope exception related to derivative
accounting unless the entity is remeasuring the hybrid instrument at fair value on a
recurring basis through earnings. Typically, such features meet the definition of a
derivative and are not clearly and closely related to a debt host (see the next
section).
5.6.3 Clearly-and-Closely-Related Analysis
A feature that presents an exposure to changes in the exchange rate
of foreign currency that is different from the debt’s currency of denomination is
not clearly and closely related to a debt host. As noted in ASC 815-15-55-212, for
example, a “foreign currency option is not clearly and closely related to issuing a
loan.” However, this guidance does not apply to a feature that does not present an
exposure to the risk of changes in the exchange rate of foreign currency that is
different from the currency in which the debt is denominated (see Section 5.6.5).
5.6.4 Derivative Analysis
The table below presents an analysis of whether a foreign currency feature embedded
in a debt host contract 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 embedded feature that presents an exposure to changes in a
foreign currency exchange rate that is based on a currency
that is different from the debt’s currency of denomination
has both an underlying (the foreign currency rate) and a
notional amount (e.g., the debt’s outstanding amount).
|
Initial net investment (see Section
1.4.2)
|
Yes
|
The initial net investment in a feature that presents an
exposure to changes in a foreign currency exchange rate that
is based on a currency that is different from the debt’s
currency of denomination 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). This 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 foreign currency exchange rates.
|
Net settlement (see Section 1.4.3)
|
Yes
|
A foreign currency feature meets the net settlement condition
because it is net cash settled.
|
As shown in the table above, a foreign currency 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 exempt from the scope of derivative accounting unless the entity is
remeasuring the hybrid instrument at fair value on a recurring basis through
earnings.
5.6.5 Convenience Clauses That Do Not Present a Foreign Currency Exposure
Sometimes, debt contracts contain a convenience clause that permits or requires
principal or interest payments or both to be made in a currency that is different
from that in which the debt is denominated. The amount of the payment is determined
by applying the current spot foreign currency exchange rate at the time of payment
to the amount owed in the debt’s currency of denomination. For example, the terms of
a debt instrument denominated in USD might specify that payments may be made in one
or more currencies at the current spot exchange rate at the time of payment. Such a
clause does not represent a foreign currency feature that should be evaluated for
bifurcation since its monetary value does not vary on the basis of a foreign
currency exchange rate.
Chapter 6 — Other Common Embedded Features
Chapter 6 — Other Common Embedded Features
6.1 Overview
As previously discussed in Chapter
4, ASC 815-15 outlines specific criteria that an entity must consider
when determining whether an embedded feature should be bifurcated from its host
contract. Chapter 5 addresses the application
of ASC 815-15 to embedded features that are commonly observed but unique to debt
host contracts. This chapter discusses the application of the guidance to other
types of common embedded features observed in debt, equity, lease, or other host
contracts. Although the concepts and examples discussed represent those that are
most commonly observed in practice, they are not intended to be all-inclusive with
respect to the types of instruments and embedded features that could exist.
6.2 Conversion, Exchange, and Indexed Features in Debt Hosts
6.2.1 Background
This section discusses the analysis of whether equity-like features — including
features that involve conversion into an issuer’s equity shares or third-party
stock as well as payment features indexed to a stock price or stock price index
— should be separated from a debt host contract and accounted for as derivatives
under ASC 815-15. See Section 6.3 for
discussion of these types of features in equity host contracts.
6.2.2 Bifurcation Analysis
6.2.2.1 General
The bifurcation analysis differs depending on whether the equity feature
economically is an equity conversion feature settleable in the debtor’s
equity shares, an exchange feature settleable in the equity shares of a
third party, or a payment feature indexed to a stock price or stock price
index. The analysis of a feature that economically represents a
share-settled redemption or indexation feature whose monetary value does not
vary on the basis of a stock price is discussed in Section 6.4. Such features do not represent
conversion or exchange options since their monetary value is not indexed to
the fair value of the shares delivered upon settlement.
6.2.2.2 Equity Conversion Feature
Debt instruments often contain features that require or permit the debt to be
converted into the debtor’s equity shares. The table below presents an
overview of the bifurcation analysis of equity conversion features embedded
in a debt host contract that are settleable in the debtor’s equity shares,
including the shares of a substantive consolidated entity. The table does
not apply to an embedded feature that economically represents a
share-settled redemption or indexation feature whose monetary value does not
vary on the basis of the debtor’s stock price (see Section 6.2.2.5). Further, an entity should
always consider the terms and conditions of a specific feature in light of
all the relevant accounting guidance before reaching a conclusion.
Bifurcation Condition
|
Condition Met?
|
Analysis
|
---|---|---|
Not clearly and closely related (see Section 4.3.2)
|
Yes
|
A change in the debtor’s stock price is not clearly
and closely related to a debt host.
|
Hybrid instrument not measured at fair value through
earnings on a recurring basis (see Section 4.3.3)
|
It depends
|
From the issuer’s perspective, debt is not measured
at fair value on a recurring basis unless the issuer
elects the fair value option in ASC 815-15 or ASC
825-10. The fair value option cannot be elected for
debt that contains a separately recognized equity
component at inception. In the case of an
outstanding share that qualifies for equity
presentation but was determined to have a debt host
contract, the instrument would not be recorded at
fair value through earnings on a recurring basis.
From the holder’s perspective, the determination of
whether the hybrid instrument is measured at fair
value, with changes recorded through earnings, will
depend on whether the instrument is (1) an equity
method investment, (2) considered a debt security in
the scope of ASC 320 (and whether the holder has
elected to apply the fair value option), or (3) an
equity security in 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
depends on multiple factors, including whether the hybrid instrument is
measured at fair value, with changes recorded through earnings, and whether
the feature meets the net settlement characteristic in the definition of a
derivative. From the issuer’s perspective, the determination also depends on
whether the scope exception in ASC 815-10-15-74(a) is met 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.
Note that 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 in
the scope of ASC 320 (and whether the holder has
elected to apply the fair value option), or (3) an
equity security in 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 in
the scope of ASC 320 (and whether the holder has
elected to apply the fair value option), or (3) an
equity security in 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 or Indexation 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.
Note that 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) 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.
Footnotes
6.3 Conversion Features in an Equity Host
6.3.1 Background
An equity instrument often contains features that require or permit the
instrument to be converted into another form of the issuer’s equity. The most
common scenario is a preferred stock agreement that contains a feature allowing
holders to convert their preferred shares into common stock (1) at the option of
one of the parties to the contract, (2) upon the occurrence of certain events,
or (3) after a certain period of time. As discussed in greater detail below,
equity conversion features generally do not require bifurcation from an equity
host contract because such features are considered clearly and closely related
to the host contract.
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)
|
Typically, no
|
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 in the
scope of ASC 320 (and whether the holder has elected to
apply the fair value option), or (3) an equity security
in 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.
|
6.4 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 in the
scope of ASC 320 (and whether the holder has elected to
apply the fair value option), or an equity security in
the scope of ASC 321.
|
Meets the definition of a derivative (see Section 4.3.4)
|
Yes
|
A redemption feature embedded in a debt host meets the
definition of a derivative irrespective of whether the
debt host contract is RCC.
|
Meets a scope exception (see Section 4.3.5)
|
No
|
There is no specific scope exception for redemption
features embedded in a debt host.
|
As shown in the table above, the determination of whether a redemption feature
must be bifurcated as a derivative tends to focus on whether the feature is
considered clearly and closely related to the debt host contract (see the next
section) unless the entity records the hybrid instrument at fair value, with
changes in fair value recorded through earnings. Such features meet the
definition of a derivative and are not exempt from the scope of derivative
accounting.
6.4.3 Clearly-and-Closely-Related Analysis
ASC Master Glossary
Prepayable
Able to be settled by either party before its scheduled
maturity.
ASC 815-15
25-41 Call
(put) options that do not accelerate the repayment of
principal on a debt instrument but instead require a
cash settlement that is equal to the price of the option
at the date of exercise would not be considered to be
clearly and closely related to the debt instrument in
which it is embedded.
25-42 The following
four-step decision sequence shall be followed in
determining whether call (put) options that can
accelerate the settlement of debt instruments shall be
considered to be clearly and closely related to the debt
host contract:
Step 1: Is the amount paid upon
settlement (also referred to as the payoff) adjusted
based on changes in an index? If yes, continue to Step
2. If no, continue to Step 3.
Step 2: Is the payoff indexed to an
underlying other than interest rates or credit risk? If
yes, then that embedded feature is not clearly and
closely related to the debt host contract and further
analysis under Steps 3 and 4 is not required. If no,
then that embedded feature shall be analyzed further
under Steps 3 and 4.
Step 3: Does the debt involve a
substantial premium or discount? If yes, continue to
Step 4. If no, further analysis of the contract under
paragraph 815-15-25-26 is required, if applicable.
Step 4: Does a contingently
exercisable call (put) option accelerate the repayment
of the contractual principal amount? If yes, the call
(put) option is not clearly and closely related to the
debt instrument. If not contingently exercisable,
further analysis of the contract under paragraph
815-15-25-26 is required, if applicable.
ASC 815-15-25-41 and 25-42 address whether embedded call or put options are
clearly and closely related to a debt host contract and apply to all features
that can accelerate the settlement of a debt instrument regardless of (1)
whether such acceleration is optional or mandatory and (2) how such features are
described in the debt’s contractual terms. As shown in the decision tree below,
ASC 815-15-25-42 identifies four steps that should be performed in the analysis
of whether a feature that can accelerate the settlement of a debt instrument is
clearly and closely related to a debt host contract.
In practice, a discount or premium that is 10 percent or more is considered
“substantial” in the analysis performed under step 3. In determining whether a
substantial premium or discount exists, an entity should compare the debt’s
initial net carrying amount to the potential payoff if the embedded call, put,
or other redemption feature is triggered. Accordingly, an entity should base its
analysis on the amount allocated to the debt for accounting purposes rather than
the total cash proceeds (e.g., if debt was issued with detachable warrants, the
amount allocated to the warrants could cause a discount on the debt).
Nevertheless, an entity should not consider a discount that results from one of
the following in its determination of whether the debt involves a substantial
discount or premium under ASC 815-15-25-42:
-
Third-party debt issuance costs that have been deducted from the initial carrying amount.
-
A discount that results from the separation of an embedded derivative under ASC 815-15.
An entity should consider the payoff of the embedded feature being analyzed in
determining whether the debt instrument was issued at a substantial premium or
discount. For example, if a debt instrument that was issued at par contains a
put option that allows the investor to redeem the instrument at 112 percent of
par value, the debt instrument would be considered to involve a substantial
premium. Similarly, if a debt instrument was issued at 90 percent of par and is
redeemable at par, the debt is considered to involve a substantial discount.
However, unpaid accrued interest does not form part of the analysis of whether a
substantial premium or discount exists.
Importantly, the debtor performs the tests as of the date on which it initially
recognizes the debt and does not subsequently reassess the tests. The investor
(or creditor) performs the tests as of the date it recognizes the debt
investment regardless of whether it acquires the debt investment in a secondary
market or upon initial issuance and would similarly not perform subsequent
reassessment. Accordingly, it is possible that the investor’s application of the
tests would have a different result than the initial evaluation performed by the
debtor if the investor acquires the debt investment in a secondary market and
the market conditions or terms at that time have changed from the time of
initial issuance.
The following table outlines and illustrates the application of the four steps in
ASC 815-15-25-42:
Steps
|
Examples of Terms That Would Result in a “Yes” Answer
|
Examples of Terms That Would Result in a “No” Answer
|
---|---|---|
“Step 1: Is the amount paid upon settlement (also
referred to as the payoff) adjusted based on changes in
an index? If yes, continue to Step 2. If no, continue to
Step 3.”
|
|
|
“Step 2: Is the payoff indexed to an underlying other
than interest rates or credit risk? If yes, then that
embedded feature is not clearly and closely related to
the debt host contract and further analysis under Steps
3 and 4 is not required. If no, then that embedded
feature shall be analyzed further under Steps 3 and
4.”
|
|
|
“Step 3: Does the debt involve a substantial premium or
discount? If yes, continue to Step 4. If no, further
analysis of the contract under paragraph 815-15-25-26 is
required, if applicable” (see Section
5.2.3).
|
|
|
“Step 4: Does a contingently exercisable call (put)
option accelerate the repayment of the contractual
principal amount? If yes, the call (put) option is not
clearly and closely related to the debt instrument. If
not contingently exercisable, further analysis of the
contract under paragraph 815-15-25-26 is required, if
applicable” (see Section
5.2.3).
|
|
|
As noted in steps 2, 3, and 4 of the decision sequence in ASC 815-15-25-42, an
entity might be required to consider the applicability of ASC 815-15-25-26 to an
embedded call, put, or other redemption feature. ASC 815-15-25-26 applies to
embedded derivatives “in which the only underlying is an interest rate or
interest rate index . . . that alters net interest payments that otherwise would
be paid or received on an interest-bearing [debt] host contract” (see Section
5.2.3.1). An option that can be exercised only upon the occurrence or
nonoccurrence of a specified event (e.g., an IPO or a change in control at the
issuer) would always have a second underlying (the occurrence or nonoccurrence
of the specified event). The existence of this second underlying would exclude
such a contract from the scope of ASC 815-15-25-26 unless the event is solely
related to interest rates (e.g., a call that may only be exercised when LIBOR is
at or above 5 percent) because the underlying would never be only an interest
rate or interest rate index (see Section 5.2.3.2).
Example 6-4
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 6-5
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.
|
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 6-6
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 6-7
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
|
Yes
|
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 in the
scope of ASC 320 (and whether the holder has elected to
apply the fair value option), or (3) an equity security
in the scope of ASC 321.
|
Meets the definition of a derivative
|
It depends
|
The determination of whether a
redemption feature embedded in an equity host meets the
definition of a derivative often depends on whether the
feature meets the net settlement criterion —
specifically, whether the underlying instrument (e.g.,
preferred stock) is RCC. The gross exchange of an equity
host instrument that is not RCC for cash does not
inherently meet the net settlement criterion.
|
Meets a scope exception
|
No
|
From the issuer’s perspective, the issuer should evaluate
whether the redemption feature meets the scope exception
for certain contracts on an issuer’s own equity. For
example, a redemption feature that allows the issuer to
call an equity instrument at a fixed price (i.e., a
physically settled reacquisition of its own equity) may
meet this exception if the option doesn’t fail any of
the criteria in ASC 815-40 (see Section 2.3.11).
From the holder’s perspective, a scope exception is not
applicable.
|
6.5.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-20 A put option that
enables the holder to require the issuer of an equity
instrument (which has been deemed to contain an equity
host contract in accordance with paragraphs
815-15-25-17A through 25-17D) to reacquire that equity
instrument for cash or other assets is not clearly and
closely related to that equity instrument. Thus, such a
put option embedded in a publicly traded equity
instrument to which it relates shall be separated from
the host contract by the holder of the equity instrument
if the criteria in paragraph 815-15-25-1(b) through (c)
are also met. That put option also shall be separated
from the host contract by the issuer of the equity
instrument except in those circumstances in which the
put option is not considered to be a derivative
instrument pursuant to paragraph 815-10-15-74(a) because
it is classified in stockholders’ equity. A purchased
call option that enables the issuer of an equity
instrument (such as common stock) to reacquire that
equity instrument would not be considered to be a
derivative instrument by the issuer of the equity
instrument pursuant to that paragraph. Thus, if the call
option were embedded in the related equity instrument,
it would not be separated from the host contract by the
issuer. However, for the holder of the related equity
instrument, the embedded written call option would not
be considered to be clearly and closely related to the
equity instrument, if the criteria in paragraph
815-15-25-1(b) through (c) were met, and shall be
separated from the host contract.
Put and call options are not considered clearly and closely related to an equity
host contract because the economic risks and characteristics of redemption
features are not the same as the economic risks and characteristics of an equity
instrument. In determining whether a put or call option is considered clearly
and closely related to an equity host, an entity should consider the payoff
profile of the settlement (see Section
4.2.2) rather than whether the redemption is settled in cash or
shares.
For example, a share-settled redemption that results in the delivery of a
variable number of shares on the basis of a fixed value would be evaluated as a
redemption feature (and not as a conversion feature). A share-settled redemption
feature would not be considered clearly and closely related to an equity host
contract, even though the contract is settled by delivery of the entity’s equity
shares. Since the share-settled redemption would be based on a fixed monetary
value payable in a variable number of shares, the economic risks and
characteristics of such feature does not expose the holder to the variability of
the underlying equity. Inversely, a cash conversion feature would typically be
considered clearly and closely related to an equity host because the conversion
value exposes the holder to similar risks and characteristics as those of an
equity holder.
6.5.4 Derivative Analysis
ASC 815-10
15-107 The potential
settlement of the debtor’s obligation to the creditor
that would occur upon exercise of a put option or call
option embedded in a debt instrument meets the net
settlement criterion as discussed beginning in paragraph
815-10-15-100 because neither party is required to
deliver an asset that is associated with the underlying.
Specifically:
-
The debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option.
-
The creditor does not receive an asset associated with the underlying.
15-109 The guidance in
paragraph 815-10-15-107 shall not be applied under
either of the following circumstances:
-
To put or call options that are added to a debt instrument by a third party contemporaneously with or after the issuance of a debt instrument. (In that circumstance, see paragraph 815-10-15-6.)
-
By analogy to an embedded put or call option in a hybrid instrument that does not contain a debt host contract.
As outlined in ASC 815-10-15-109, 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 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 6-8
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.
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 in the
scope of ASC 320 (and whether the holder has elected to
apply the fair value option), or (3) an equity security
in 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 6-9
Preferred Stock With a Dividend Adjustment
Feature
Company C issued preferred stock on January 15, 20X2,
that pays cumulative quarterly dividends at a 5 percent
annual rate. If a business combination transaction is
consummated after December 31, 20X2, the stated
percentage for the dividend payment will increase by 1
percent (i.e., the “dividend rate adjustment”) in each
month after the transaction. The preferred stock is
redeemable at the option of the investor and therefore
subject to remeasurement in accordance with the
temporary equity guidance in ASC 480-10-S99-3A. Assume
that C has asserted that the fair value of the dividend
rate adjustment is less, by more than a nominal amount,
than what would have been required to invest in a
freestanding contract with a feature similar to the
dividend rate adjustment feature.
The following analysis summarizes the evaluation of
whether the dividend rate adjustment requires
bifurcation from the equity host contract:
From the Issuer’s Perspective
-
Not clearly and closely related — Condition met. The economic characteristic of the dividend rate adjustment is not clearly and closely related to the equity host since an equity host would typically absorb variability rather than be protected from variability related to adverse events.
-
Not remeasured at fair value — Condition met. The preferred stock would not be subject to recurring fair value measurements, with changes in fair value recorded through earnings. (Importantly, even though the preferred stock is subject to remeasurement, the changes in its redemption value would typically be recorded through equity as dividends rather than through earnings.)
-
Meets the definition of a derivative — Condition met. To meet the definition of a derivative in accordance with ASC 815-10-15-83, the dividend rate adjustment must have all of the following:
-
Underlying, notional amount, payment provision — The dividend rate adjustment has an underlying (i.e., the occurrence of a business combination transaction) and the payment of additional dividends (i.e., 1 percent for each month after December) as a payment provision.
-
Initial net investment — As noted above, the fair value of the dividend rate adjustment is less, by more than a nominal amount, than what would have been required to invest in a freestanding contract with terms that are similar to those of the embedded feature. Thus, the condition above is met.
-
Net settlement — The dividend rate adjustment results in a one-way delivery of cash to the holder of C’s preferred stock. Therefore, the dividend rate adjustment provides for contractual net settlement.
On the basis of the above analysis, the dividend rate adjustment has all the characteristics of a derivative instrument and therefore meets the bifurcation requirement in ASC 815-15-25-1(c). -
Because all of the criteria in ASC
815-15-25-1 are met, the dividend rate adjustment
requires bifurcation from the preferred stock as a
derivative instrument.
From the Holder’s
Perspective
From the perspective of the preferred
stockholder, the only consideration that would be
different from the analysis above is that in some cases
the hybrid instrument may be recorded at fair value
through earnings. The holder would account for its
investment in C’s preferred stock as a debt security
within the scope of ASC 320 since the preferred stock is
redeemable at the option of the investor.2 If the holder accounts for its investment in C’s
preferred stock at fair value, with changes in fair
value recorded through earnings (i.e., as a trading
security or under the fair value option), it would not
bifurcate the dividend rate adjustment since the
criterion in ASC 815-15-25-1(b) would not be met.
Importantly, if the holder classifies the investment as
an available-for-sale debt security, changes in fair
value would be recorded through OCI and, therefore, the
holder would be required to bifurcate the dividend rate
adjustment from the host contract and record changes in
its fair value through earnings.
Footnotes
2
The definition of a debt
security in ASC 320 specifically includes
investments in preferred stock that are redeemable
at the investor’s option. In this example, it
would not be appropriate to account for the
preferred stock as an equity security within the
scope of ASC 321.
6.7 Embedded Commitments (Including PIK Interest/Dividend Features)
6.7.1 Background
A credit facility or tranche debt financing might include both an initial term
loan and commitments to obtain additional term loans on specified future dates.
Further, some debt and preferred stock instruments contain a paid-in-kind (PIK)
interest or dividend feature, respectively, which requires or permits the issuer
to pay interest or dividends in the form of additional debt or stock that has
the same terms as the original instrument. In substance, a PIK interest feature
in a debt host is a loan commitment since it permits or requires the issuer to
issue additional debt with specified terms to settle future interest payments.
Similarly, a PIK dividend feature in an equity host is a commitment to issue
additional equity interests.
Note that the discussion in this section only applies if the entity has
determined that the host contract and the PIK commitments represent one combined
unit of account (see Section 3.3 of
Deloitte’s Roadmap Distinguishing Liabilities From
Equity for further discussion of unit of account
considerations). If the commitments represent separate units of account (e.g.,
the commitments are legally detachable and separately exercisable from the host
contract), they should be evaluated as freestanding commitments and would be
subject to other guidance.
6.7.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of a PIK
commitment embedded in a debt or equity host contract. However, an entity should
always consider the terms and conditions of a specific feature in light of all
the relevant accounting guidance before reaching a conclusion.
Bifurcation Condition
|
Condition Met?
|
Analysis
|
---|---|---|
Not clearly and closely related (see Section 4.3.2)
|
It depends
|
A loan commitment is not clearly and closely related to a
debt host contract if it includes features that are not
clearly and closely related to a debt instrument.
Similarly, a commitment to issue additional equity
shares would not be clearly and closely related to an
equity host contract if it includes features that are
not clearly and closely related to an equity instrument.
|
Hybrid instrument not measured at fair value through
earnings on a recurring basis (see Section 4.3.3)
|
It depends
|
From the issuer’s perspective, legal form debt is not
measured at fair value on a recurring basis unless the
issuer elects the fair value option in ASC 815-15 or ASC
825-10. The fair value option cannot be elected for debt
that contains a separately recognized equity component
at inception. In the case of (1) an outstanding share
that qualifies for equity presentation but was
determined to have a debt host contract or (2) an equity
host contract, the issuer would not measure the
instrument at fair value, with changes in fair value
recorded through earnings, on a recurring basis.
From the perspective of a holder of a debt or equity host
contract, the determination of whether the hybrid
instrument is measured at fair value, with changes in
fair value recorded through earnings, depends on whether
the instrument is considered a debt security within the
scope of ASC 320 (and the related classification of the
debt security) or an equity security within the scope of
ASC 321.
|
Meets the definition of a derivative (see Section 4.3.4)
|
It depends
|
The evaluation of whether a PIK commitment meets the
definition of a derivative depends on whether it meets
the net settlement characteristic in the definition of a
derivative.
|
Meets a scope exception (see Section 4.3.5)
|
It depends
|
A debtor should evaluate whether the commitment qualifies
for the loan commitment scope exception (see Section 2.3.9). This
scope exception is not available if the commitment is
held by the potential creditor or investor, nor would it
be available for a PIK dividend feature embedded in an
equity instrument.
|
6.7.3 Clearly-and-Closely-Related Analysis
A loan commitment is not clearly and closely related to a debt host contract if
it includes features that are not clearly and closely related to a debt
instrument. For example, if a commitment requires an entity to issue (1) debt
that is convertible into the debtor’s equity shares or (2) both debt and
warrants on the debtor’s equity shares, the commitment would not be clearly and
closely related to a debt host contract since the debtor’s stock price is not
clearly and closely related to a debt host. Similarly, a commitment to issue
term debt would not be clearly and closely related to a preferred stock
agreement with an equity host since the risks and rewards of holding debt are
not consistent with those of an equity holder. However, a commitment to issue
additional equity shares could be clearly and closely related to an equity host
contract. The clearly-and-closely-related analysis will depend on the specifics
of the embedded loan commitment 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, a PIK interest feature embedded in a debt
contract may qualify for the loan commitment scope exception, which is discussed
further in Section 2.3.9; however, such
scope exception would not be applicable to a PIK dividend feature embedded in an
equity contract. Further, an investor in a debt instrument that contains a PIK
interest feature may be ineligible to apply the loan commitment scope exception
if the loans are mortgage loans that are expected to be held for sale once
funded (see Section 2.3.9 for further
details).
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 in 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 in the scope of ASC 320 (and the related
classification of the debt security) or (2) an equity
security in the scope of ASC 321.
|
Meets the definition of a derivative
(see Section 4.3.4)
|
Yes
|
Payment features that are based on
specified volumes of sales or service revenues meet the
definition of a derivative (see Section 6.9.4).
|
Meets a scope exception (see Section
4.3.5)
|
It depends
|
ASC 815-10-15-59 and 15-60 contains a
scope exception for non-exchange-traded contracts with
payments based on specified volumes of sales or service
revenues of one of the parties to the contract. See
Section 2.3.5.3 for discussion of this
scope exception.
|
As shown in the table above, the determination of whether a revenue-based payment
feature requires bifurcation as an embedded feature will vary on the basis of
the nature of the host contract, whether the hybrid instrument is remeasured at
fair value through earnings, and whether the revenue-based payment feature is
exempt from the scope of derivative accounting if a specific scope exception is
met.
6.9.3 Clearly-and-Closely-Related Analysis
As indicated above, revenue-based payment features are most commonly identified
in lease host contracts. An example of such a provision would be a scenario in
which a lessee’s monthly lease payment is composed of a base component plus a
sales component (e.g., a base fee of $100,000 plus 10 percent of the lessee’s
total sales from that month). Aside from the likely application of a derivative
scope exception, if an entity were to determine whether the payment feature is
clearly and closely related to the lease host contract, it would conclude that
the underlying nature and economics of the revenue-based payment is not clearly
and closely related to the risks and rewards of a lease host. That is, the
economic risks and rewards of a lease contract typically would not expose the
lessee or lessor to the variability of the revenue of one party to the
contract.
The economic characteristics and risks of a payment feature indexed to specified
volumes or sales or service revenues would also not be considered clearly and
closely related to the economic characteristics and risks of a debt instrument
(i.e., interest rates, credit risk, and inflation rates). Similarly,
revenue-based payment features are not generally considered to be clearly and
closely related to an equity host because the risks and economics of such
features do not align with the risks and economics of an equity holder. Although
there may be a correlation between an entity’s revenues and its equity value,
the economic risks and characteristics would typically not be sufficiently
aligned so as to be considered clearly and closely related.
In practice, we would generally not expect an entity to perform this evaluation
because revenue-indexed features will often meet the scope exception in ASC
815-10-15-59(d). Accordingly, an entity may not even need to consider whether
the revenue-based payment is clearly and closely related to the host because the
scope exception alone would indicate that bifurcation is not required (see
Example 2-13 for illustration of this scope
exception).
6.9.4 Derivative Analysis
The table below presents an analysis of whether a payment
feature indexed to specified volumes of sales or service revenues meets the
definition of a derivative (see Section 4.3.4). However, an entity should
always consider the terms and conditions of a specific feature in light of the
applicable accounting guidance before reaching a conclusion.
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
---|---|---|
Underlying and notional amount or
payment provision (see Section 1.4.1)
|
Yes
|
A feature that could adjust the payments
of a contract on the basis of specified volumes of sales
or service revenues has both an underlying (specified
volumes of sales or service revenues) and a notional
amount (e.g., the debt’s outstanding amount, number of
shares) or a payment provision.
|
Initial net investment (see Section
1.4.2)
|
Yes
|
The initial net investment in an
embedded feature is its fair value (i.e., the amount
that would need to be paid to acquire the feature on a
stand-alone basis without the host contract). Generally,
a feature that adjusts the payments of a contract on the
basis of specified volumes of sales or service revenues
has an initial net investment that is smaller than would
be required for a direct investment that has the same
exposure to changes in the value of the specified
volumes of sales or service revenues (since the
investment in the host contract does not form part of
the initial net investment in the embedded feature).
|
Net settlement (see Section
1.4.3)
|
Yes
|
Adjustments to the payments of a host
contract on the basis of specified volumes of sales or
service revenues meet the net settlement condition
because the feature is cash settled (neither party is
required to deliver an asset that is associated with the
underlying and whose principal amount, stated amount,
face value, number of shares, or other denomination is
equal to the feature’s notional amount).
|
As shown in the table above, a payment feature indexed to specified volumes of
sales or service revenues typically meets the definition of a derivative.
However, such a feature often qualifies for a scope exception. Section 2.3.5.3 includes a variety of examples
for which this scope exception applies.
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 6-10
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 6-11
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
As of the date of this publication, the FASB’s research agenda 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. While the timing of any
possible standard setting is currently unknown, entities should be aware
that future standard setting on this topic could result in new or
different accounting for ESG-linked features than what is discussed in
this section. Stakeholders should monitor the status of the research
project for developments.
6.10.6 Additional Considerations
Before reaching a conclusion about the accounting for a payment provision, an
entity should always consider the terms and conditions of a specific feature in
light of all the relevant accounting guidance (e.g., whether a scope exception
on derivative accounting is available; see Chapter
2). An entity is not required to recognize a derivative related
to normal contractual remedies for a breach of contract whose occurrence the
entity can prevent. For example, an entity is not required to separate an
indemnification clause that holds each party harmless against damages, losses,
or claims resulting from the breach of contract or gross negligence.
The fair value of a payment feature embedded in debt host might
be minimal, depending on the likelihood that the feature will be triggered and,
if so, on its potential amount (e.g., a feature in which a minor adjustment must
be made to the interest rate upon an event whose likelihood of occurring is
remote). In practice, therefore, entities sometimes determine and document that
they are not required to make accounting entries upon debt issuance to recognize
a feature that must be bifurcated as a derivative under ASC 815-15. Any such
conclusion must be appropriately supported on the basis of materiality. A
determination that a feature has a minimal fair value at inception does not
negate the requirement to account for it as a derivative. Accordingly, if an
entity makes such a determination, it should also monitor its facts and
circumstances in each reporting period to evaluate whether the feature’s fair
value or a change to it is significant and therefore must, under U.S. GAAP
requirements, be reflected in the entity’s financial statements. For instance,
if a feature that must be bifurcated as a derivative liability is determined to
have a fair value that is not materially different from zero when the debt is
issued and the fair value increases to $50,000 during the next reporting period,
the change in fair value from zero to $50,000 should be reflected as a loss
during that reporting period; the change cannot be recognized as a debt discount
after the issuance of the debt.
The entity should also consider the appropriate level of aggregation in
identifying and evaluating embedded features (see Section 4.2.2). The terms of a debt contract might contain a cap
on the total amount of additional interest that would be paid under additional
interest provisions. For example, the debt terms might specify that in no event
will additional interest be paid at a rate in excess of 0.50 percent regardless
of the number of events or circumstances giving rise to the requirement to pay
such additional interest. This means that the total amount of additional
interest that might have to be paid on the debt is not necessarily simply the
sum of the additional interest that might need to be paid under each of the
provisions that triggers such additional interest payments. For instance, if one
or more additional interest features have been triggered such that the total
amount of additional interest payable is equal to the cap, there would be no
incremental amount payable if another such feature is triggered. In this
circumstance, the potential payoff of each additional interest provision and the
payoffs under the other provisions to which the cap applies are interdependent.
Under the payoff profile approach for identifying embedded features (see
Section 4.2.2), it is appropriate to
evaluate such additional interest features as one combined embedded feature
rather than as separate embedded features for each of the triggers. As a
consequence, an additional interest feature that would have been considered
clearly and closely related to a debt host if it had been evaluated on a
stand-alone basis (e.g., an additional interest feature triggered by a change in
the issuer’s creditworthiness; see Section
5.3) might have to be combined with other additional interest
features that are not considered clearly and closely related to a debt host in
the evaluation of whether the combined feature is clearly and closely related to
the debt host.
6.11 Illustrative Example: Convertible Preferred Stock With Multiple Features (Debt and Equity Host Considerations)
The comprehensive example below applies the guidance in ASC
815-15-25-1 to convertible preferred stock that has multiple embedded features that
must be evaluated for bifurcation.
Example 6-12
Overview and Background
Entity R, a private company, issues redeemable convertible
preferred stock at par to multiple investors with the
following features:
- Redemption option — After the third anniversary of the issuance, investors may redeem the security for an amount of cash equal to the greater of (1) the face value of the security or (2) the fair value of the underlying common stock.
- Conversion option — Investors may convert the security at any time into the issuer’s common stock on a one-for-one basis.
The below evaluation of the embedded
features will contemplate two scenarios — one in which the
preferred stock has an equity host and one in which it has a
debt host (see Section
4.3.2.3.2 for details on the determination of
the host contract nature). In both scenarios, the preferred
stock qualifies for equity classification in accordance with
ASC 480 in R’s financial statements.
As stated above, after the third anniversary, the redemption
option allows the holder to put the security to the issuer
for cash equal to the greater of (1) the security’s face
value or (2) the underlying common stock’s fair value.
Effectively, this “greater of” redemption option gives the
holder of the security the ability to either net cash settle
the conversion option or obtain a return of the originally
invested amount. When the embedded features are identified
under an economic payoff approach, the right to redeem the
preferred stock for cash equal to the fair value of the
underlying common stock would be attributed to a conversion
feature rather than a redemption feature. Entity R would
separately evaluate the redemption feature as only the right
to redeem the security for cash equal to the security’s face
value.
The preferred stock cannot contractually be settled in such a
way that the holder would not recover substantially all of
its initial recorded investment. Further, there is no
potential scenario in which the holder could achieve a rate
of return on the preferred stock that at least doubles its
initial rate of return and is twice what would otherwise be
the market return.
In this scenario, the preferred stock contains two payoff
profiles that should be evaluated as embedded features: (1)
the holder’s right to redeem the security at its face value
for cash (the “redemption feature”) and (2) the holder’s
right to convert the security into equity that can be
settled in cash or in shares (the “conversion feature”). The
redemption feature and the conversion feature must be
analyzed separately under ASC 815-15-25-1.
First Criterion: Not
Clearly and Closely Related
Both R and the investor would apply the
not-clearly-and-closely-related criterion to the redemption
and conversion features, as described separately below.
Redemption Feature
- Equity host — If the host contract is an equity host, the redemption feature that enables the holder to require the issuer to reacquire that equity instrument for cash (at face value) is not considered clearly and closely related to that equity host under ASC 815-15-25-20. Evaluation of the additional bifurcation criteria would be required.
- Debt host — If R concludes
that the host contract is a debt host, it would look
to ASC 815-15-25-26 and ASC 815-15-25-41 through
25-43 in determining whether the redemption feature
is clearly and closely related to that debt host, as
follows:
- Consider the four-step
decision sequence in ASC 815-15-25-42:
-
“Step 1: Is the amount paid upon settlement (also referred to as the payoff) adjusted based on changes in an index? If yes, continue to Step 2. If no, continue to Step 3.”Answer: No. The redemption is at the security’s face value and is not adjusted on the basis of changes in an index.
-
“Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, then that embedded feature shall be analyzed further under Steps 3 and 4.”Answer: Not applicable because of the answer in step 1.
-
“Step 3: Does the debt involve a substantial premium or discount? If yes, continue to Step 4. If no, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.”Answer: No substantial premium or discount exists in the consideration of any premium or discount that exists upon both (1) issuance and (2) settlement of this feature. Accordingly, further evaluation under ASC 815-15-25-26 is required.
-
“Step 4: Does a contingently exercisable call (put) option accelerate the repayment of the contractual principal amount? If yes, the call (put) option is not clearly and closely related to the debt instrument. If not contingently exercisable, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.”Answer: Not applicable because of the answer in step 3.
-
- Evaluate the guidance in ASC
815-15-25-26:
-
Does the feature pass the negative yield and double-double tests (see Sections 5.2.3.3 and 5.2.3.4 for the applicable guidance)?Answer: On the basis of the background information provided, the preferred stock cannot contractually be settled in such a way that the holder would not recover substantially all of its initial recorded investment. There is also no potential scenario in which the holder could achieve a rate of return on the preferred stock through the redemption feature that at least doubles its initial rate of return and is twice what would otherwise be the market return. The upside provided by the redemption equal to the fair value of the underlying common stock is evaluated as a potential cash settlement of the conversion option. Thus, the feature would not pass the negative yield or double-double test.
-
- Consider the four-step
decision sequence in ASC 815-15-25-42:
In accordance with the steps above, including evaluating the
guidance in ASC 815-15-25-26, the redemption feature is
clearly and closely related to the host contract, so
bifurcation of the redemption feature from a debt host would
not be required. Evaluation of the additional bifurcation
criteria is not necessary.
Conversion Feature
- Equity host — If the host contract is more akin to equity, the conversion feature and host contract would be clearly and closely related and this condition would not be met. Because all three criteria must be met for bifurcation, further evaluation would not be needed to conclude that no bifurcation is required.
- Debt host — If the host contract is more akin to debt, guidance in ASC 815-15-25-51 would be applicable, which indicates that conversion options are generally not clearly and closely related to debt hosts. In that case, R and the investor would conclude that the conversion feature is not clearly and closely related to the debt host and further analysis of the other criteria would be necessary to determine whether the feature requires bifurcation.
Second Criterion: Not
Remeasured at Fair Value
From R’s perspective, the preferred stock issued is not
eligible to be measured at fair value, with changes in fair
value recognized in earnings. ASC 815 and ASC 825 prohibit
this election for equity instruments issued by an entity
that are classified in stockholders’ equity (or mezzanine
equity) in the issuer’s statement of financial position.
From R’s perspective, the second criterion is met.
From the investors’ perspective, provided
that the preferred stock investment is not accounted for
under the equity method, the preferred stock would be
classified as a debt security in accordance with ASC 320
because of the provision that allows the holder to redeem
the shares. Depending on how the debt security is classified
(i.e., trading, AFS, or HTM) and whether the investor has
elected to apply the fair value option, the debt security
may or may not be recorded at fair value, with changes in
fair value recorded through earnings. If the investment is
already recorded at fair value, with changes recognized
through earnings, the second criterion would not be met and
neither of the embedded features would be bifurcated from
the host contract. If the investment is not recorded
at fair value, with changes recorded through earnings (e.g.,
an AFS-classified debt security for which the fair value
option has not been elected), the second criterion would be
met.
Third Criterion:
Derivative on a Stand-Alone Basis
To be bifurcated, an embedded feature in a hybrid instrument
must, on a freestanding basis, meet the definition of a
derivative in ASC 815-10-15-83. The determination of whether
the definition is met often focuses on the definition’s
third component (i.e., the net settlement characteristic).
Usually, the other two components of the definition of a
derivative (i.e., (1) an underlying and a notional amount or
payment provision and (2) no or little initial net
investment) are met for an embedded feature in a hybrid
financial instrument.
Redemption Feature
- Equity host — Whether the redemption feature meets the net settlement characteristic in the definition of a derivative generally depends on whether the hybrid contract is publicly traded and RCC. For R, the preferred stock is not publicly traded and is not considered RCC. Therefore, this criterion is not met under this specific fact pattern because the redemption feature does not meet the definition of a derivative.
- Debt host — Evaluation is not required since the redemption feature is clearly and closely related to the host contract.
Conversion Feature
- Equity host — Evaluation is not required since the conversion feature is clearly and closely related to the host contract.
- Debt host — Because the conversion feature may be net-cash-settled, the holder is effectively able to realize the change in the conversion option’s fair value without physically settling the option in shares. As a result, the conversion feature is considered net-settleable and meets the definition of a derivative. There are no applicable scope exceptions from derivative accounting; specifically, since the conversion feature is settled in cash at the option of the holder, the conversion feature would not be eligible for the scope exception for contracts in an entity’s own equity under ASC 815-40. This exception would have never been applicable to the investor, regardless of the ability to settle the conversion feature in cash. As a result, the third criteria is met for the conversion feature.
Conclusion
As shown above, under the guidance in ASC 815-15-25-1, R’s
determination of whether the conversion and redemption
features require bifurcation depends largely on (1) the
nature of the host contract and (2) whether the evaluation
is performed from the issuer’s or holder’s perspective.
If the host contract has an equity host, the redemption
feature will not require bifurcation because the feature on
its own does not meet the definition of a derivative (since
R is a private company and its equity securities are not
RCC). The conversion feature would similarly not require
bifurcation because the conversion feature and the equity
host contract are clearly and closely related.
If the host contract has a debt host, the redemption feature
would not require bifurcation because the feature is clearly
and closely related to the host contract. However, from the
issuer’s perspective, the conversion feature would require
bifurcation because (1) the conversion feature would not be
clearly and closely related to the host contract, (2) the
preferred stock is not measured at fair value, and (3) the
conversion feature meets the definition of a derivative
because it can be settled net in cash at the holder’s
option. From the holder’s perspective, the determination of
whether the conversion feature requires bifurcation depends
on how the ASC 320 debt security is classified.
As indicated in this example, the facts and circumstances
surrounding a particular transaction significantly affect
the determination of whether bifurcation of a particular
feature is required.
Chapter 7 — Presentation and Disclosures
Chapter 7 — Presentation and Disclosures
7.1 Overview
This chapter discusses financial statement presentation and
disclosure matters related generally to derivatives. Chapter 6 of Deloitte’s Roadmap Hedge
Accounting provides additional detail on presentation and
disclosure matters related specifically to hedging instruments.
7.2 Balance Sheet
ASC 815-10
25-1
An entity shall recognize all of its derivative instruments
in its statement of financial position as either assets or
liabilities depending on the rights or obligations under the
contracts.
30-1
All derivative instruments shall be measured initially at
fair value.
35-1
All derivative instruments shall be measured subsequently at
fair value.
Derivatives within the scope of ASC 815 must be (1) recognized on the balance sheet
as assets or liabilities and (2) measured at fair value in each reporting period.
7.2.1 Balance Sheet Offsetting
7.2.1.1 Conditions for Offsetting Derivatives
ASC 815-10
45-1 Subtopic 210-20
establishes the criteria for offsetting amounts in
the balance sheet.
As noted in ASC 815-10-45-1, “the criteria for offsetting amounts in the
balance sheet” are established by ASC 210-20. Specifically, ASC 210-20-45-1
identifies four conditions that must all be met to offset asset and
liability amounts:
-
Each of two parties owes the other determinable amounts.
-
The reporting party has the right to set off the amount owed with the amount owed by the other party.
-
The reporting party intends to set off.
-
The right of setoff is enforceable at law.
Each of these conditions is discussed further in the sections below.
7.2.1.1.1 Each of Two Parties Owes the Other Determinable Amounts
The first condition in ASC 210-20-45-1 is that each of two parties must
owe the other a determinable amount. Under this condition, the assets
and the liabilities need to involve the same two counterparties.
Example 7-1
Swaps With Several Counterparties — Which
Counterparties Qualify for Offsetting?
Cactus Co. has four interest rate swaps with the
following counterparties and respective fair values:
-
Swap 1 with Banker A — fair value of $1 million.
-
Swap 2 with Banker B — fair value of ($400,000).
-
Swap 3 with Banker C — fair value of $500,000.
-
Swap 4 with Banker A — fair value of ($700,000).
The net fair value of the four swaps is
$400,000.
Cactus Co. evaluates which of the four swaps
could qualify for offsetting on the balance sheet.
In accordance with the condition in ASC
210-20-45-1(a), Cactus Co. cannot offset amounts
that arise from different counterparties.
Therefore, the only swaps that could potentially
qualify for offsetting would be those involving
Banker A (i.e., swaps 1 and 4). As long as the
other criteria in ASC 210-20-45-1 and ASC
815-10-45-5 are met for swaps 1 and 4, Cactus Co.
could record a derivative asset for $300,000,
representing its net relationship with Banker A.
7.2.1.1.2 Right to Set Off
The second condition in ASC 210-20-45-1 is that the reporting entity must
have “the right to set off the amount owed with the amount owed by the
other party.” ASC 210-20-20 defines the right of setoff as “a debtor’s
legal right, by contract or otherwise, to discharge all or a portion of
the debt owed to another party by applying against the debt an amount
that the other party owes to the debtor.” In many cases, derivative
instruments may be subject to a master netting arrangement, which is
described as follows in ASC 815-10-45-5:
A master netting arrangement exists if the reporting entity has
multiple contracts, whether for the same type of derivative
instrument or for different types of derivative instruments,
with a single counterparty that are subject to a contractual
agreement that provides for the net settlement of all contracts
through a single payment in a single currency in the event of
default on or termination of any one contract.
7.2.1.1.3 Intent to Set Off
The third condition in ASC 210-20-45-1 is that the reporting entity must
have the intent to exercise its “right to set off the amount owed with
the amount owed by the other party.” However, ASC 815-10-45-3 through
45-7 provide an exception for derivatives (and associated amounts)
related to the intent to set off.
ASC 815-10
45-3 The following
guidance addresses offsetting certain amounts
related to derivative instruments. For purposes of
this guidance, derivative instruments include
those that meet the definition of a derivative
instrument but are not included in the scope of
this Subtopic.
45-4 Paragraph superseded
by Accounting Standards Update No. 2018-09.
45-5 In accordance with
paragraph 210-20-45-1, but without regard to the
condition in paragraph 210-20-45-1(c), a reporting
entity may offset fair value amounts recognized
for derivative instruments and fair value amounts
recognized for the right to reclaim cash
collateral (a receivable) or the obligation to
return cash collateral (a payable) arising from
derivative instrument(s) recognized at fair value
executed with the same counterparty under a master
netting arrangement. Solely as it relates to the
right to reclaim cash collateral or the obligation
to return cash collateral, fair value amounts
include amounts that approximate fair value. The
preceding sentence shall not be analogized to for
any other asset or liability. The fair value
recognized for some contracts may include an
accrual component for the periodic unconditional
receivables and payables that result from the
contract; the accrual component included therein
may also be offset for contracts executed with the
same counterparty under a master netting
arrangement. A master netting arrangement exists
if the reporting entity has multiple contracts,
whether for the same type of derivative instrument
or for different types of derivative instruments,
with a single counterparty that are subject to a
contractual agreement that provides for the net
settlement of all contracts through a single
payment in a single currency in the event of
default on or termination of any one contract.
45-6 A reporting entity
shall make an accounting policy decision to offset
fair value amounts pursuant to the preceding
paragraph. The reporting entity’s choice to offset
or not must be applied consistently. A reporting
entity shall not offset fair value amounts
recognized for derivative instruments without
offsetting fair value amounts recognized for the
right to reclaim cash collateral or the obligation
to return cash collateral. A reporting entity that
makes an accounting policy decision to offset fair
value amounts recognized for derivative instruments
pursuant to the preceding paragraph but determines
that the amount recognized for the right to reclaim
cash collateral or the obligation to return cash
collateral is not a fair value amount shall continue
to offset the derivative instruments.
45-7 A reporting entity
that has made an accounting policy decision to
offset fair value amounts is not permitted to
offset amounts recognized for the right to reclaim
cash collateral or the obligation to return cash
collateral against net derivative instrument
positions if those amounts either:
- Were not fair value amounts
- Arose from instruments in a master netting arrangement that are not eligible to be offset.
Under the exception in ASC 815-10-45-5, an entity does not need to
consider whether it intends to set off amounts owed under a master
netting arrangement executed with the counterparty when evaluating the
conditions for offsetting those amounts on the balance sheet. As long as
the other three conditions in ASC 210-20-45-1 are met, an entity may
elect to net the following amounts, subject to the master netting
arrangement, regardless of whether it intends to set off its rights and
obligations:
-
Fair value amounts recognized for derivatives.
-
Fair value amounts recognized for the right to reclaim cash collateral that arises from derivatives (receivables).
-
Fair value amounts recognized for the obligation to return cash collateral arising from derivatives (payables).
-
Any accrual component of the periodic unconditional receivable and payable under the derivatives that is included in the contracts’ fair value.
As noted above, an entity may enter into multiple derivative contracts
with the same counterparty under a master netting arrangement that
provides for a single net settlement of all financial instruments
covered by the agreement in the event of default on, or termination of,
any one contract. In some cases, such arrangements may require either
entity to post collateral with the other entity, depending on which
entity is in a net asset position.
For example, under some master netting arrangements, the entity that is
not in the net asset position is required to provide cash collateral to
the entity that is in the net asset position. After the cash collateral
is posted, the entity that is not in the net asset position has a right
to reclaim the cash collateral (a receivable) and the counterparty has
an obligation to return the cash collateral (a payable). If the other
three conditions in ASC 210-20-45-1 are met, all of the amounts could be
offset on the balance sheet.
However, it is not appropriate for an entity to offset separately
recorded accrued receivables or payables against the fair value amounts
of derivative assets or liabilities and associated fair value amounts
for cash collateral receivables or payables entered into with the same
counterparty. Physically settled derivatives (e.g., forward contracts to
purchase or sell commodities or bonds) require delivery of an asset.
Upon delivery of the asset underlying the physically settled derivative,
but before the cash payment, an entity removes the derivative from its
balance sheet and records separate inventory and accrued payable
balances. Therefore, for contracts involving multiple deliveries, an
entity often has a current payable for the latest delivery and a
derivative asset or liability for any remaining deliveries. Once a
receivable or payable (other than for cash collateral) is reported
separately from its related derivative, however, that receivable or
payable can no longer be offset against derivative assets or liabilities
and associated cash collateral receivables or payables that are carried
at fair value.
For net-cash-settled derivatives (e.g.,
fixed-for-floating interest rate swaps), there may be no separately
recorded inventory, accrued receivable, or payable line item. Instead,
the fair value of the derivative may include an accrual component, as
described in ASC 815-10-45-5:
[A] reporting entity may offset fair value
amounts recognized for derivative instruments and fair value
amounts recognized for the right to reclaim cash collateral (a
receivable) or the obligation to return cash collateral (a
payable) arising from derivative instrument(s) recognized at
fair value executed with the same counterparty under a master
netting arrangement. . . . The fair value recognized for some
contracts may include an accrual
component for the periodic unconditional receivables and
payables that result from the contract; the accrual component
included therein may also be offset for contracts executed with
the same counterparty under a master netting arrangement.
[Emphasis added]
Such an accrual component may exist in the fair value of a
net-cash-settled derivative because it is common for a time lag to exist
between (1) the date on which the floating price of the contract is set
and (2) the date on which cash settlement occurs (e.g., if the contract
settlement amount is based on the price of an index established on March
31 even though the contract does not cash-settle until April 30). The
fact that the recorded fair value of a net-cash-settled derivative
contains an accrual component does not affect an entity’s ability to
offset contracts that are carried at fair value. The accrual component
is not separately reported from its related derivative.
If all the conditions in ASC 210-20-45-1 are satisfied, it still may be
possible to offset separately recorded accrued receivables and payables
against similar separately recorded payables or receivables held by the
same counterparty.
Example 7-2
Accrued Payables in Multiple-Delivery
Contract
Maize Company enters into a derivative contract
on January 1, 20X8, to buy 100 bushels of corn at
$10 per bushel on both January 31, 20X8, and
February 28, 20X8, for delivery to a specified
location. The contract is accounted for at fair
value. Assume that the right of setoff exists and
that Maize’s policy under ASC 210-20 and ASC
815-10-45-4 through 45-7 is to offset fair value
amounts. The market price of corn on January 1,
20X8, is $10 per bushel. From January 1, 20X8,
through January 31, 20X8, the price of corn rises
to $12 per bushel.
The table below shows the accounting for the
derivative during the first period. (For
simplicity, only the first-period effects are
shown in the table. The derivative contract has
another settlement in February 20X8, which is not
shown. The price of corn is assumed to be the same
in January 20X8 and February 20X8, and present
value is not considered in the measurement of the
derivative’s fair value.)
The table illustrates that as of January 31,
20X8, the physically settled derivative results in
a separately recorded accrued payable balance of
$1,000 for the first-period settlement, and the
remaining derivative amount represents the
derivative asset related to the delivery that will
occur in period 2. The accrued payable represents
a discrete obligation that cannot be offset
against the related derivative balance despite
Maize’s election to set off under ASC 210-20 and
ASC 815-10-45-4 through 45-7.
ASC 815-10-45-6 notes that an entity “shall make an accounting policy
decision to offset fair value amounts . . . [and the] choice to offset
or not must be applied consistently.” In addition, ASC 815-10-45-6
clarifies that an entity “shall not offset fair value amounts recognized
for derivative instruments without offsetting fair value amounts
recognized for the right to reclaim cash collateral or the obligation to
return cash collateral.” However, if an entity determines that the
amount recognized for such a cash collateral receivable or payable is
not at, or does not approximate, the fair value amount, those amounts
should not be offset against the derivatives.
7.2.1.1.4 Setoff Enforceable at Law
The last condition in ASC 210-20-45-1 that must be met to offset assets
and liabilities on the balance sheet is that the right to set off must
be legally enforceable.
7.2.1.1.5 Allocation of Fair Value for Items Subject to Master Netting Arrangement
An entity that elects to offset fair value amounts in accordance with ASC
210-20 and ASC 815-10-45-4 through 45-7 is required to offset (1) fair
value amounts recognized for derivative instruments and (2) fair value
amounts recognized for the right to reclaim cash collateral (a
receivable) or the obligation to return cash collateral (a payable) arising from a derivative instrument (or instruments) recognized at fair value and “executed with the same counterparty under a master netting arrangement.” FASB Staff Position (FSP) FIN 39-1 amended the guidance in FASB Interpretation 39, which is now codified in ASC 815-10-45-4 through 45-7, to include the receivables and payables related to cash collateral. In paragraph A8 of the Background Information and Basis for Conclusions of FSP FIN 39-1, the Board made the following observation:
Master netting arrangements may include instruments that either
(a) do not meet the definition of a derivative instrument or (b) meet the definition of a derivative instrument but are not recognized at fair value due to the scope exceptions in Statement 133 and other applicable GAAP. The Board agreed that
including these instruments in a master netting arrangement
would not preclude a reporting entity from offsetting fair value
amounts recognized for derivative instruments under the same
master netting arrangement as those instruments. Because this
Interpretation permits offsetting of fair value amounts
recognized for the right to reclaim cash collateral or the
obligation to return cash collateral arising from derivative
instruments recognized at fair value only, the Board agreed that
the reporting entity should determine the amount of the cash
collateral receivable or payable that can be offset against the
net derivative position using a reasonably supportable
methodology.
In paragraph A8 of FASB FSP FIN 39-1, the Board noted that a master
netting arrangement also may include instruments that either (1) “do not meet the definition of a derivative instrument” (e.g., an accrued receivable or payable) or (2) “meet the definition of a derivative instrument but are not included in the scope of Statement 133 [codified
in ASC 815-10]” (e.g., NPNS). The Board indicated that such instruments
did “not preclude a reporting entity from offsetting fair value amounts
recognized for derivative instruments under the same master netting
arrangement.” However, an entity cannot offset a receivable or payable
for the right to reclaim or obligation to return cash collateral that is
not associated with a derivative instrument recognized at fair value.
Therefore, an entity must “determine the amount of the cash collateral
receivable or payable that can be offset against the net derivative
position using a reasonably supportable methodology.”
No one method is appropriate or preferable in all circumstances;
selecting an appropriate allocation method depends on the specific facts
and circumstances associated with the arrangement. Any method that
results in an arbitrary allocation of all cash collateral receivables or
payables — either entirely to contracts that qualify for the right of
setoff under ASC 210-20-45-1 and ASC 815-10-45-5 or entirely to
contracts that do not qualify for the right of setoff — is not
reasonable and would be inappropriate. An entity should document its
allocation method and apply that method consistently.
In addition, ASC 815-10-50-8 requires an entity that elects to offset
fair value amounts to separately disclose (1) cash collateral receivable
or payable amounts that are offset against net derivative positions and
(2) amounts for cash collateral receivables or payables under master
netting arrangements that were not offset against net derivative
positions because they were not eligible for the right of setoff.
Without specific guidance on allocation, entities should develop a method
that is appropriate for the circumstances. To assess whether a proposed
method is reasonable, they should consider the following:
-
Is there an allocation formula specified in the master netting arrangement? If the master netting arrangement dictates the level of collateral that must be provided for each contract covered by the agreement on the basis of a specified formula, that formula should be used to determine the level of collateral associated with derivatives carried at fair value. If the arrangement does not explicitly describe how to calculate and allocate collateral, it may be appropriate for the entity to consult with its legal counsel to understand how the collateral arrangement works.
-
Does the master netting arrangement provide any means of determining how the collateral would be allocated if a default occurred under the arrangement?
-
If the level of collateral is negotiated between the parties to the master netting arrangement, does the negotiation history provide a basis for a reasonable allocation?
-
Would it be appropriate to allocate the collateral according to the fair value of each contract subject to the master netting arrangement? It may be reasonable to do so in certain situations (e.g., if the level of collateral is based on the total fair value of the contracts covered by the master netting arrangement), such as the following:
-
Example 1 — Assume that the fair values of the contracts covered by the master netting arrangement are as follows:In this case, the terms of the master netting arrangement require the counterparty to post collateral because the entity is in a net asset position (on the basis of the contracts’ fair value). Thus, the entity records a cash collateral payable, which is recognized at an amount that approximates fair value. Under this method, three-fifths of the cash collateral payable would be allocable to the derivative contracts and must be offset against those derivative contracts in the entity’s statement of financial position.
-
Example 2 — Assume that the fair values of the contracts covered by the master netting arrangement are as follows:In this case, the terms of the master netting arrangement require the entity to post collateral to the counterparty because the entity is in a net liability position (on the basis of the contracts’ net fair value). Thus, the entity records a cash collateral receivable, which is recognized at an amount that approximates fair value. In this example, the requirement to post cash collateral is driven entirely by the entity’s net liability position in NPNS contracts that do not qualify for the right of setoff under ASC 210-20-45-1 and ASC 815-10-45-5. Therefore, it would not be appropriate for the entity to allocate any of its cash collateral receivable to the derivative contracts that qualify for the right of setoff.
-
7.2.2 Classification as Current or Noncurrent
ASC Master Glossary
Current Assets
Current assets is used to designate cash and other assets
or resources commonly identified as those that are
reasonably expected to be realized in cash or sold or
consumed during the normal operating cycle of the
business. See paragraphs 210-10-45-1 through 45-4.
Current Liabilities
Current liabilities is used principally to designate
obligations whose liquidation is reasonably expected to
require the use of existing resources properly
classifiable as current assets, or the creation of other
current liabilities. See paragraphs 210-10-45-5 through
45-12.
ASC 815 does not include any specific guidance on classifying derivative assets
or liabilities on a classified balance sheet; however, ASC 210-10-45 provides
general guidance on the classification of assets and liabilities. The ASC master
glossary specifies that current assets are “those that are reasonably expected
to be realized in cash or sold or consumed during the normal operating cycle of
the business,” and current liabilities are those that are “reasonably expected
to require the use of existing resources properly classifiable as current
assets, or the creation of other current liabilities.”
ASC 210-10
45-3 A one-year time period
shall be used as a basis for the segregation of current
assets in cases where there are several operating cycles
occurring within a year. However, if the period of the
operating cycle is more than 12 months, as in, for
instance, the tobacco, distillery, and lumber
businesses, the longer period shall be used. If a
particular entity has no clearly defined operating
cycle, the one-year rule shall govern.
As noted in ASC 210-10-45-3, a typical operating cycle is one year, although in
some circumstances the operating cycle could be longer. The remainder of this
discussion assumes that an entity’s operating cycle is one year.
A derivative asset or liability should be classified on the basis of its
settlement terms. If a derivative matures within a year of the balance sheet
date, it should be classified as a current asset or liability. If (1) the
counterparty to a derivative has an unconditional right to terminate or settle
the arrangement within a year of the balance sheet date and (2) the derivative
is a liability (i.e., it has a negative fair value), it should be classified as
a current liability.
In addition, if a derivative involves multiple settlements (e.g., an interest
rate swap), an entity will need to use judgment in allocating the derivative
into its current and noncurrent portions. We believe that the fair value related
to the cash flows that are required to occur within one year of the
balance sheet date would represent the current asset or current liability
portion, whereas the fair value related to the cash flows that are required to
occur after one year of the balance sheet date would represent the
noncurrent asset or liability portion. It is possible for the current portion of
a derivative to be an asset and the noncurrent portion to be a liability, and
vice versa.
7.3 Income Statement
ASC 815-10
45-8
Except for the guidance in the following paragraph and
paragraph 815-10-45-10, this Subtopic does not provide
guidance about the classification in the income statement of
a derivative instrument’s gains or losses, including the
adjustment to fair value for a contract that newly meets the
definition of a derivative instrument.
Derivative Instruments Held for Trading
Purposes
45-9
Gains and losses (realized and unrealized) on all derivative
instruments within the scope of this Subtopic shall be shown
net when recognized in the income statement, whether or not
settled physically, if the derivative instruments are held
for trading purposes. On an ongoing basis, reclassifications
into and out of trading shall be rare.
Options Granted to Employees and
Nonemployees
45-10
Subsequent changes in the fair value of an option that was
granted to a grantee and is subject to or became subject to
this Subtopic shall be included in the determination of net
income. (See paragraphs 815-10-55-46 through 55-48A and
815-10-55-54 through 55-55 for discussion of such an
option.) Changes in fair value of the option award before
vesting shall be characterized as compensation cost in the
grantor’s income statement. Changes in fair value of the
option award after vesting may be reflected elsewhere in the
grantor’s income statement.
As discussed in Chapter 3, changes in the fair
value of derivative assets and liabilities are typically recorded as gains and
losses in the income statement. ASC 815 is silent on classification in the income
statement of gains and losses related to derivatives that are not in qualifying
hedging relationships. Consequently, there is diversity in practice regarding the
presentation of such results.
Although income statement geography is not prescribed by ASC 815, the standard is
clear that gains and losses on all derivative instruments that are not in hedging
relationships (i.e., not in either qualifying hedges or economic hedges) must be
shown net when recognized on the income statement. See Section 6.3 of Deloitte’s Roadmap Hedge Accounting for further discussion of the income
statement classification of gains and losses of derivatives in both qualifying and
economic hedging relationships.
We further understand that in the SEC staff’s view, if a derivative does not qualify
for hedge accounting, an entity should record all income, expenses, and fair value
changes related to that derivative (whether realized or unrealized) in one line item
in the financial statements, and this line item should not change. For example, a
realized gain or loss recognized for a nonhedging derivative should be recorded in
the same income statement line item as any unrealized gains or losses previously
recognized for that instrument.
In a speech at the 2003 AICPA Conference on Current SEC
Developments, Gregory Faucette, then a professional accounting fellow in the OCA,
made extensive comments on the income statement classification of derivatives. Mr.
Faucette indicated that it would be inappropriate for an entity to present gains and
losses on a nonhedging derivative under multiple captions in its income statement.
For example, an entity should not classify separately the unrealized gains and
losses on an economic derivative under the caption “risk management activities”
while classifying realized gains and losses on the same derivative (e.g., periodic
or final cash settlements) in a separate revenue or expense line item that may be
associated with the underlying in the economic hedge.
7.4 Cash Flow Statement
See Section 7.4 of Deloitte’s
Roadmap Statement of Cash Flows for a
detailed discussion of the classification of cash flows for derivatives on the
statement of cash flows.
7.5 Disclosures
The disclosure requirements of ASC 815 apply to all interim and annual reporting
periods for which a balance sheet and income statement are presented.
ASC 815-10
50-4I
If information on derivative instruments (or nonderivative
instruments that are designated and qualify as hedging
instruments pursuant to paragraphs 815-20-25-58 and
815-20-25-66) is disclosed in more than a single note to
financial statements, an entity shall cross-reference from
the derivative instruments (or nonderivative instruments)
note to other notes in which derivative-instrument-related
information is disclosed.
Disclosures about derivatives and hedging activities are not required to be presented
in a single footnote to the financial statements. However, ASC 815-10-50-4I notes
that if the disclosures required by ASC 815-10-50 are made in more than one
footnote, an entity should provide a cross-reference from the footnote regarding the
derivative instruments (or nonderivative hedging instruments) to the other notes in
which information about derivatives and hedging activities is disclosed. For
information about the disclosure requirements related to fair value measurements,
see Deloitte’s Roadmap Fair Value Measurements and
Disclosures (Including the Fair Value Option).
7.5.1 Qualitative Disclosures About Objectives of Derivatives
ASC 815-10
General
50-1 An entity with
derivative instruments (or nonderivative instruments
that are designated and qualify as hedging instruments
pursuant to paragraphs 815-20-25-58 and 815-20-25-66)
shall disclose information to enable users of the
financial statements to understand all of the
following:
-
How and why an entity uses derivative instruments (or such nonderivative instruments)
-
How derivative instruments (or such nonderivative instruments) and related hedged items are accounted for under Topic 815
-
How derivative instruments (or such nonderivative instruments) and related hedged items affect all of the following:
-
An entity’s financial position
-
An entity’s financial performance
-
An entity’s cash flows.
-
50-1A An entity that holds or
issues derivative instruments (or nonderivative
instruments that are designated and qualify as hedging
instruments pursuant to paragraphs 815-20-25-58 and
815-20-25-66) shall disclose all of the following for
every annual and interim reporting period for which a
statement of financial position and statement of
financial performance are presented:
-
Its objectives for holding or issuing those instruments
-
The context needed to understand those objectives
-
Its strategies for achieving those objectives
-
Information that would enable users of its financial statements to understand the volume of its activity in those instruments.
50-1B For item (d) in paragraph
815-10-50-1A, an entity shall select the format and the
specifics of disclosures relating to its volume of such
activity that are most relevant and practicable for its
individual facts and circumstances. Information about
the instruments in items (a) through (c) in paragraph
815-10-50-1A shall be disclosed in the context of each
instrument’s primary underlying risk exposure (for
example, interest rate, credit, foreign exchange rate,
interest rate and foreign exchange rate, or overall
price). Further, those instruments shall be
distinguished between those used for risk management
purposes and those used for other purposes. Derivative
instruments (and nonderivative instruments that are
designated and qualify as hedging instruments pursuant
to paragraphs 815-20-25-58 and 815-20-25-66) used for
risk management purposes include those designated as
hedging instruments under Subtopic 815-20 as well as
those used as economic hedges and for other purposes
related to the entity’s risk exposures.
50-2 The instruments addressed
by items (a) through (c) in paragraph 815-10-50-1A shall
be distinguished between each of the following:
- Derivative instruments (and
nonderivative instruments as noted in items (1)(i)
and (1)(iii) of this paragraph) used for risk
management purposes, distinguished between each of
the following:
- Derivative instruments (and
nonderivative instruments) designated as hedging
instruments, distinguished between each of the
following:
- Derivative instruments (and nonderivative instruments) designated as fair value hedging instruments
- Derivative instruments designated as cash flow hedging instruments
- Derivative instruments (and nonderivative instruments) designated as hedging instruments for hedges of the foreign currency exposure of a net investment in a foreign operation.
- Derivative instruments used as economic hedges and for other purposes related to the entity’s risk exposures.
- Derivative instruments (and
nonderivative instruments) designated as hedging
instruments, distinguished between each of the
following:
- Derivative instruments used for other purposes.
50-4 For derivative instruments
not designated as hedging instruments under Subtopic
815-20, the description shall indicate the purpose of
the derivative activity.
50-5 Qualitative disclosures
about an entity’s objectives and strategies for using
derivative instruments (and nonderivative instruments
that are designated and qualify as hedging instruments
pursuant to paragraphs 815-20-25-58 and 815-20-25-66)
may be more meaningful if such objectives and strategies
are described in the context of an entity’s overall risk
exposures relating to all of the following:
-
Interest rate risk
-
Foreign exchange risk
-
Commodity price risk
-
Credit risk
-
Equity price risk.
Those additional qualitative
disclosures, if made, should include a discussion of
those exposures even though the entity does not manage
some of those exposures by using derivative instruments.
An entity is encouraged, but not required, to provide
such additional qualitative disclosures about those
risks and how they are managed.
50-5A The quantitative
disclosures about derivative instruments may be more
useful, and less likely to be perceived to be out of
context or otherwise misunderstood, if similar
information is disclosed about other financial
instruments or nonfinancial assets and liabilities to
which the derivative instruments are related by
activity. Accordingly, in those situations, an entity is
encouraged, but not required, to present a more complete
picture of its activities by disclosing that
information.
An entity with derivatives should disclose sufficient information to enable
financial statement users to understand how and why it uses derivatives in the
context of its operations.
ASC 815-10-50-1 requires disclosures about the following:
-
How and why an entity uses derivative instruments . . .
-
How derivative instruments . . . are accounted for under Topic 815
-
How derivative instruments . . . affect all of the following:
-
An entity’s financial position [i.e., balance sheet]
-
An entity’s financial performance [i.e., comprehensive income statements]
-
An entity’s cash flows [i.e., cash flow statement].
-
In addition, ASC 815-10-50-1A requires an entity to describe in the footnotes the
objectives, context, and strategies for holding or issuing derivatives. ASC
815-10-50-1B clarifies that this discussion should be “in the context of each
instrument’s primary underlying risk exposure (for example, interest rate,
credit, foreign exchange rate, interest rate and foreign exchange rate, or
overall price).” Such disclosures should be broken down further between those
used for “risk management purposes” and those used for other purposes. According
to ASC 815-10-50-1B, instruments used for risk management purposes include both
those designated in qualifying hedging relationships and “those used as economic
hedges and for other purposes related to the entity’s risk exposures.” For
specific discussion of disclosures applicable to derivatives (and
nonderivatives) involved in hedging activities, see Deloitte’s Roadmap Hedge Accounting.
ASC 815-10-50-4 requires an entity to describe the purpose of any activities
involving derivatives that are not designated in qualifying hedging
relationships. SEC registrants should be mindful that if any metrics are
reported related to economic hedging or other general risk management
activities, they must consider the guidance in the SEC’s non-GAAP measure rules
when making any adjustments. For further discussion of non-GAAP measures, see
Deloitte’s Roadmap Non-GAAP Financial Measures and
Metrics.
7.5.2 Overall Quantitative Disclosures
ASC 815-10
50-4A An entity that holds or
issues derivative instruments (and nonderivative
instruments that are designated and qualify as hedging
instruments pursuant to paragraphs 815-20-25-58 and
815-20-25-66) shall disclose all of the following for
every annual and interim reporting period for which a
statement of financial position and statement of
financial performance are presented:
- The location and fair value amounts of derivative instruments (and such nonderivative instruments) reported in the statement of financial position
- The location and amount of the
gains and losses on derivative instruments (and
such nonderivative instruments) and related hedged
items reported in any of the following:
-
The statement of financial performance
-
The statement of financial position (for example, gains and losses initially recognized in other comprehensive income).
-
- The total amount of each income and expense line item presented in the statement of financial performance in which the results of fair value or cash flow hedges are recorded.
50-4E The quantitative
disclosures required by paragraphs 815-10-50-4A through
50-4CCC shall be presented in tabular format. If a
proportion of a derivative instrument is designated and
qualifying as a hedging instrument and a proportion is
not designated and qualifying as a hedging instrument,
an entity shall allocate the related amounts to the
appropriate categories within the disclosure tables.
Example 21 (see paragraph 815-10-55-182) illustrates the
disclosures described in paragraphs 815-10-50-4A through
50-4E.
ASC 815-10-50-4A establishes overall requirements for quantitative disclosures
related to the impact of derivatives (and nonderivative hedging instruments) on
an entity’s balance sheet, income statement, and statement of OCI. Each of these
requirements is discussed in further detail in the next sections.
ASC 815-10-50-4E notes that the quantitative disclosures required in ASC
815-10-50-4A through 50-4CCC must “be presented in tabular format.” Many of the
quantitative disclosures required by ASC 815 require entities to separate the
presentation of derivatives designated in qualifying hedging relationships from
the presentation of those that are not in qualifying hedging relationships.
According to ASC 815-10-50-4E, “[i]f a proportion of a derivative instrument is
designated and qualifying as a hedging instrument and a proportion is not
designated and qualifying as a hedging instrument, an entity shall allocate the
related amounts to the appropriate categories within the disclosure tables.” See
Examples 6-5 and 6-6 in Deloitte’s Roadmap Hedge
Accounting.
7.5.2.1 Quantitative Disclosures Related to the Balance Sheet
ASC 815-10
50-4A An entity that holds
or issues derivative instruments (and nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66) shall disclose all of
the following for every annual and interim reporting
period for which a statement of financial position
and statement of financial performance are
presented:
- The location and fair value amounts of derivative instruments (and such nonderivative instruments) reported in the statement of financial position . . . .
50-4B The disclosures
required by item (a) in the preceding paragraph
shall comply with all of the following:
-
The fair value of derivative instruments (and nonderivative instruments that are designated and qualify as hedging instruments pursuant to paragraphs 815-20-25-58 and 815-20-25-66) shall be presented on a gross basis, even when those instruments are subject to master netting arrangements and qualify for net presentation in the statement of financial position in accordance with Subtopic 210-20 or paragraphs 815-10-45-5 through 45-7, as applicable.
-
Cash collateral payables and receivables associated with those instruments shall not be added to or netted against the fair value amounts.
-
Fair value amounts shall be presented as separate asset and liability values segregated between each of the following:
-
Those instruments designated and qualifying as hedging instruments under Subtopic 815-20, presented separately by type of contract (for example, interest rate contracts, foreign exchange contracts, equity contracts, commodity contracts, credit contracts, other contracts, and so forth)
-
Those instruments not designated as hedging instruments, presented separately by type of contract.
-
-
The disclosure shall identify the line item(s) in the statement of financial position in which the fair value amounts for these categories of derivative instruments are included.
Amounts required to be reported for nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66 shall be the carrying
value of the nonderivative hedging instrument, which
includes the adjustment for the foreign currency
transaction gain or loss on that instrument.
50-4E The quantitative
disclosures required by paragraphs 815-10-50-4A
through 50-4CCC shall be presented in tabular
format. If a proportion of a derivative instrument
is designated and qualifying as a hedging instrument
and a proportion is not designated and qualifying as
a hedging instrument, an entity shall allocate the
related amounts to the appropriate categories within
the disclosure tables. Example 21 (see paragraph
815-10-55-182) illustrates the disclosures described
in paragraphs 815-10-50-4A through 50-4E.
ASC 815-10-50-4A(a) requires an entity to provide a tabular disclosure of the
location and fair value of derivative instruments and nonderivative hedging
instruments reported on the balance sheet. ASC 815-10-50-40B provides more
details on how to comply with ASC 815-10-50-4A(a) by clarifying the
following items:
-
The fair value of derivatives and nonderivative hedging instruments should “be presented on a gross basis,” even if those amounts are offset with other derivative instruments in accordance with ASC 210-20.
-
Payables and receivables related to cash collateral associated with derivatives should “not be added to or netted against the fair value amounts.”
-
Assets and liabilities should be presented separately, and the fair value amounts should be segregated between the following:
-
Instruments that are designated in qualifying hedging relationships, “presented separately by type of contract (for example, interest rate contracts, foreign exchange contracts, equity contracts, commodity contracts, credit contracts, other contracts, and so forth).”
-
Instruments that are not designated as hedging contracts, “presented separately by type of contract” (see above).
-
-
The disclosure should “identify the line item(s)” on the balance sheet in which the derivatives are included for each of these categories.
-
For nonderivative hedging instruments included in the tabular disclosures, entities should report the carrying value of the nonderivative instrument in accordance with ASC 830.
ASC 815-10-55-182 provides an illustrative example of the tabular disclosures
required by ASC 815-10-50-4A. The portion of the illustration related to the
balance sheet (as required by ASC 815-10-50-4A(a)) is reproduced below.
ASC 815-10
55-182 This Example illustrates
the disclosure in tabular format of fair value
amounts of derivative instruments and gains and
losses on derivative instruments as required by
paragraphs 815-10-50-4A through 50-4E:
. . .
7.5.2.1.1 Tabular Disclosure of Amounts That Are Offset in Accordance With ASC 210
If an entity elects to offset its derivative assets and liabilities in
accordance with ASC 815-10-45-1 through 45-7 and ASC 210-20-45-1 through
45-5, it presents those derivative assets and liabilities on a net basis
in the statement of financial position. As noted above, ASC
815-10-50-4B(a) requires entities to separately disclose the fair value
of all derivative assets and liabilities on a gross basis, “even when
[the derivative] instruments are subject to master netting arrangements
and qualify for net presentation in the statement of financial position
in accordance with Subtopic 210-20.” Accordingly, an entity may be
required to show on the balance sheet (1) gross derivative asset
balances that are reported as “contra” liabilities and (2) gross
derivative liability balances that are included as “contra” assets.
Example 7-3
Derivatives Subject to Offset — Balance Sheet
Line Item for Tabular Disclosure
Assume that TreyCo (1) has a portfolio of
derivatives containing contracts that are in both
asset and liability positions as of the reporting
date and (2) has appropriately elected, in
accordance with ASC 210-20, to present those
contracts net in its statement of financial
position as net liabilities within the line item
for “derivative liabilities.” TreyCo must still
present the gross derivative assets within that
portfolio as “derivative liabilities” in the
tabular disclosures. ASC 815-10-50-4B(d) requires
such disclosures to “identify the line item(s) in
the statement of financial position in which the
fair value amounts for these categories of
derivative instruments are included.”
In addition to providing the required disclosure
identifying the “line item(s) in the statement of
financial position in which the fair value amounts
for these categories of derivative instruments are
included,” an entity is permitted to provide
supplemental disclosure regarding (1) the basis
for its presentation in the tabular disclosures,
(2) the nature of the relationship between the
offsetting asset and liability derivative
contracts, and (3) how those amounts are
ultimately presented in the statement of financial
position. (It is recommended that the entity
provide such disclosure in a footnote to the
table.)
The following is an example of what TreyCo could
disclose to comply with requirements for the
tabular disclosure of the fair values of
derivative instruments in a statement of financial
position, including disclosure of which
instruments are subject to master netting
arrangements and presented net in the statement of
financial position:
7.5.2.1.2 Receivables or Payables Related to Cash Collateral From Derivatives
ASC 815-10-45-5 permits an entity to “offset fair value amounts
recognized for derivative instruments and fair value amounts recognized
for the right to reclaim cash collateral (a receivable) or the
obligation to return cash collateral (a payable) arising from derivative
instrument(s) recognized at fair value executed with the same
counterparty under a master netting arrangement.” ASC 815-10-45-6 notes
that a “reporting entity shall not offset fair value amounts recognized
for derivative instruments without offsetting fair value amounts
recognized for the right to reclaim cash collateral or the obligation to
return cash collateral.” Moreover, ASC 815-10-50-4B(b) states that
“[c]ash collateral payables and receivables associated with [the
derivative] instruments shall not be added to or netted against the fair
value amounts.”
Although an entity is not permitted to net collateral payables or
receivables against the fair values of its derivatives in the tabular
disclosures, ASC 815-10-50 does not prohibit an entity from providing
supplemental disclosure in its tabular presentations. Therefore, an
entity may indicate — by adding a footnote to its tabular disclosure or
providing separate columnar presentation or another similar presentation
— the fair values of its collateral payables or receivables that are (1)
offset against the fair values of its derivative assets and liabilities
and (2) presented net in its statement of financial position. The entity
should consistently apply this presentation to all similar derivative
contracts and relationships. Also, any supplemental disclosure should
clearly indicate how the related amounts are presented in the statement
of financial position.
7.5.2.1.3 Derivatives With a Portion Classified as Current and a Portion Classified as Noncurrent
An entity may classify a portion of a derivative contract as current and
a portion as noncurrent in its classified balance sheet (see Section
7.2.2). Under ASC 815-10-50-4A(a) and ASC 815-10-50-4B,
the entity is required to identify the location of the fair value
amounts included in the statement of financial position. Therefore, in
the tabular disclosures required by those paragraphs, the entity should
separately present the fair value amounts of the derivative that are
related to (1) the portion classified as current and (2) the portion
classified as noncurrent.
7.5.2.2 Trading Derivatives
ASC 815-10
50-4F For derivative
instruments that are not designated or qualifying as
hedging instruments under Subtopic 815-20, if an
entity’s policy is to include those derivative
instruments in its trading activities (for example,
as part of its trading portfolio that includes both
derivative instruments and nonderivative or cash
instruments), the entity can elect to not separately
disclose gains and losses as required by paragraph
815-10-50-4CC provided that the entity discloses all
of the following:
- The gains and losses on its
trading activities (including both derivative
instruments and nonderivative instruments)
recognized in the statement of financial
performance, separately by major types of items,
for example:
- Fixed income/interest rates
- Foreign exchange
- Equity
- Commodity
- Credit.
- The line items in the statement of financial performance in which trading activities gains and losses are included
- A description of the nature of its trading activities and related risks, and how the entity manages those risks.
If the disclosure option in this paragraph is
elected, the entity shall include a footnote in the
required tables referencing the use of alternative
disclosures for trading activities. Example 21 (see
paragraph 815-10-55-182) illustrates a footnote
referencing the use of alternative disclosures for
trading activities. Example 22 (see paragraph
815-10-55-184) illustrates the disclosure of the
information required in items (a) and (b).
If an entity has a policy of including derivative instruments that are not in
qualifying hedging relationships in its trading activities, it may elect to
exclude such “trading derivatives” from its tabular disclosures about gains
and losses required by ASC 815-10-50-4CC. However, if the entity elects to
exclude trading derivatives, it should:
-
Include a footnote in the tabular disclosures that references this election for trading activities.
-
Present a description of (1) its trading activities and related risks and (2) how the entity manages those risks.
-
Disclose the gains and losses on its trading activities (including both derivatives and nonderivatives) separately by major types of items. ASC 815-10-50-4F provides the following examples of major types of items:
-
Fixed income/interest rates
-
Foreign exchange
-
Equity
-
Commodity
-
Credit.
-
However, if the derivative instruments are not held for trading purposes, an
entity may not elect to exclude such instruments from the tabular
disclosures required by ASC 815-10-50-4CC solely because they are not
designated in qualifying hedging relationships. For an entity to elect to
provide alternative disclosures for trading derivatives, its use of the
derivatives must meet the definition of trading in U.S. GAAP. The ASC master
glossary defines trading as follows:
An activity involving securities
sold in the near term and held for only a short period of time. The term
trading contemplates a holding period generally measured in hours and
days rather than months or years. See paragraph 948-310-40-1 for
clarification of the term trading for a mortgage banking entity.
Example 22 in ASC 815-10-55-184, which is reproduced below, provides an
illustration of quantitative disclosures related to trading activities.
ASC 815-10
55-184 This Example
illustrates one approach for presenting the
quantitative information required under paragraph
815-10-50-4F when an entity elects the alternative
disclosure for gains and losses on derivative
instruments included in its trading activities. The
Example does not address all possible ways of
complying with the alternative disclosure
requirements under that paragraph. Many entities
already include the required information about their
trading activities in other disclosures within the
financial statements. Paragraph 815-10-50-4I states
that, if information on derivative instruments (or
nonderivative instruments that are designated and
qualify as hedging instruments pursuant to
paragraphs 815-20-25-58 and 815-20-25-66) is
disclosed in more than a single note to financial
statements, an entity shall cross-reference from the
derivative instruments (or nonderivative
instruments) note to other notes in which
derivative-instrument-related information is
disclosed.
The revenue related to each category includes
realized and unrealized gains and losses on both
derivative instruments and nonderivative
instruments.
7.5.2.3 Not-for-Profit Entities
ASC 815-10
50-4G For purposes of the
disclosure requirements beginning in paragraph
815-10-50-4A, not-for-profit entities within the
scope of Topic 954 should present a similarly
formatted table. Those entities shall refer to
amounts within their performance indicator, instead
of in income, and amounts outside their performance
indicator, instead of in other comprehensive income.
Not-for-profit entities not within the scope of
Topic 954 shall disclose the gain or loss recognized
in changes in net assets using a similar format. All
not-for-profit entities also would indicate which
class or classes of net assets (without donor
restrictions or with donor restrictions) are
affected.
Under ASC 815-10-50-4G, NFPs within the scope of ASC 954 are required to
present tabular disclosures related to the impact of derivatives and hedging
activities in tables that are formatted similarly to those discussed above,
even if those entities do not present statements of income and OCI. In such
disclosures, the term “income” should be replaced by the entity’s
“performance indicator” and the term “other comprehensive income” should be
replaced by “outside [of the] performance indicator.”
If an NFP is not within the scope of ASC 954, it should present the gain or
loss recognized in changes in net assets in a similar format and indicate
which class or classes of net assets are affected.
7.5.3 Liquidity Risk Disclosures
7.5.3.1 Credit-Risk-Related Contingent Features
ASC 815-10
50-4H An entity that holds or
issues derivative instruments (or nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66) shall disclose all of
the following for every annual and interim reporting
period for which a statement of financial position
is presented:
-
The existence and nature of credit-risk-related contingent features
-
The circumstances in which credit-risk-related contingent features could be triggered in derivative instruments (or such nonderivative instruments) that are in a net liability position at the end of the reporting period
-
The aggregate fair value amounts of derivative instruments (or such nonderivative instruments) that contain credit-risk-related contingent features that are in a net liability position at the end of the reporting period
-
The aggregate fair value of assets that are already posted as collateral at the end of the reporting period
-
The aggregate fair value of additional assets that would be required to be posted as collateral if the credit-risk-related contingent features were triggered at the end of the reporting period
-
The aggregate fair value of assets needed to settle the instrument immediately if the credit-risk-related contingent features were triggered at the end of the reporting period.
Amounts required to be reported for nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66 shall be the carrying
value of the nonderivative hedging instrument, which
includes the adjustment for the foreign currency
transaction gain or loss on that instrument. Example
23 (see paragraph 815-10-55-185) illustrates a
credit-risk-related contingent feature disclosure.
The annual and interim disclosures required by ASC 815-10-50-4H are designed
to highlight liquidity risk associated with derivative liabilities that are
not fully collateralized, particularly the potential for collateral calls or
immediate settlement. The disclosures are focused on derivative liabilities
because, as a result of triggering events, an entity may be required to
deliver cash or other assets as collateral or to settle such contracts
early. Some refer to the ASC 815-10-50-4H disclosures as “run on the bank”
disclosures. More commonly, they are referred to as “liquidity risk
disclosures.”
7.5.3.1.1 Identification of Net Derivative Liabilities Subject to Liquidity Risk Disclosures
Entities may find it useful to perform the steps below when determining
which contracts are subject to the disclosure requirements in ASC
815-10-50-4H (note that steps 2 and 3 can be reversed if desired).
7.5.3.1.1.1 Step 1 — Identify All Derivative Liabilities Recognized at Fair Value
An entity performs this step on a gross basis at the contract level
(i.e., it does not offset a liability against an asset in accordance
with ASC 815-10-45-1 through 45-8 or other portfolio approach). The
remaining population of contracts should be consistent with the
derivative liabilities disclosed under ASC 815-10-50-4A and 50-4B.
7.5.3.1.1.2 Step 2 — Identify the Subset of Derivative Liabilities That Are Fully Collateralized
On the basis of discussions with the FASB staff, we understand that
the scope of ASC 815-10-50-4H encompasses any derivative liabilities
(with credit-risk-related contingent features) that (1) are
accounted for at fair value under ASC 815 and (2) are not fully
collateralized as of the balance sheet date and therefore represent
a liquidity exposure to the entity. Note that a fully collateralized
derivative, by contrast, represents a derivative liability (from the
reporting entity’s perspective) for which the reporting entity has
posted sufficient collateral as of the balance sheet date to avoid
any additional payments upon an early settlement of the contract
(for this purpose, early settlement is presumed to occur as of the
balance sheet date on the basis of the derivative’s GAAP fair value
unless the contract explicitly refers to another early settlement
calculation). In other words, a derivative liability is considered
fully collateralized only if it is effectively “prepaid” (through
the collateral), which would eliminate any additional liquidity
exposure to the entity as of the balance sheet date.
The term “collateral” refers to assets provided to, or legally
restricted for the benefit of, a counterparty in support of an
obligation; to be considered collateral for a derivative liability,
the assets must be contractually linked to the derivative. Entities
should not consider letters of credit (LCs) posted with the
counterparty to be assets posted as collateral. In addition, when
determining whether a derivative liability is fully collateralized,
an entity should not consider (1) derivative assets recognized at
fair value, (2) contracts subject to the NPNS scope exception in ASC
815-10-15-13, or (3) receivables or other items that are subject to
the same master netting arrangement as the derivative liability.
These amounts (whether related to open positions or receivables)
arise on the basis of separate transactions between the parties,
whereas collateral arises on the basis of terms and conditions
within a specific contract or master netting arrangement.
When an entity is determining whether a derivative liability is fully
collateralized, it is acceptable to adopt a consistent approach in
which the entity defines collateral as cash (in the same currency as
the derivative’s settlement) and thus only considers a derivative
liability fully collateralized when it is fully collateralized with
cash. This approach is consistent with the principle that the
derivative liability must effectively be prepaid (with no additional
liquidity exposure) as of the balance sheet date. Cash provided to a
counterparty is different from other forms of collateral in that it
carries no collection risk and is not subject to fluctuations in
value (as opposed to land, for example).
Note that for derivative liquidity disclosures, entities should not
think of “net” in the context of ASC 815-10-45-1 through 45-7 or ASC
210-20-45-1 through 45-53 (see Section 7.2.1). The
meaning of the term “net liability position,” as used in the ASC
815-10-50-4H disclosure requirements, differs from how a net
derivative asset or liability may be determined under ASC
815-10-45-1 through 45-7 and ASC 210-20-45-1 through 45-5. More
specifically, under a master netting arrangement with a single
counterparty, an entity may have both derivative asset and
derivative liability contracts that, upon satisfaction of the
criteria in ASC 815-10-45-1 through 45-7 and ASC 210-20-45-1 through
45-5, may be offset and presented as a single net asset in the
entity’s balance sheet. Despite presentation as a net asset,
however, each individual derivative liability within that master
netting arrangement that has a credit-risk-related contingent
feature would be subject to the ASC 815-10-50-4H disclosures unless
the liability was fully collateralized.
Example 7-4
Derivative Not Fully Collateralized
Mercury Provisions has a forward to purchase
titanium that is a liability with a fair value of
$100 as of the balance sheet date. It has posted
collateral of $75, and if an early settlement
occurs on the balance sheet date, it would be
required to pay an additional $25 to the
counterparty. In this example, the derivative is
not fully collateralized because Mercury would
need to make an additional payment upon early
settlement.
After the contracts identified in step 2 are eliminated (i.e., step 1
population less step 2 subset), the remaining subset of derivative
contracts represents all derivative instruments considered to be in
a net liability position for the ASC 815-10-50-4H disclosures (i.e.,
derivative liability contracts that are not fully collateralized).
7.5.3.1.1.3 Step 3 — Identify Remaining Subset of Derivative Contracts Containing Credit-Risk-Related Contingent Features
From the remaining contracts (derivative instruments in a net
liability position), the entity identifies the subset of derivative
contracts that contains one or more credit-risk-related contingent
features. When assessing whether individual features represent
credit-risk-related contingent features that must be disclosed under
ASC 815-10-50-4H, an entity should consider the following
guidelines, which were developed on the basis of discussions with
the FASB staff:
- Disclosure is not limited to features that trigger cash payments. Although ASC 815-10-50-4H generally focuses on liquidity exposure, the guidance encompasses any feature that would require the use of an entity’s “assets.”
- The feature could reside in a contract or governing arrangement (e.g., master netting arrangement). Many derivatives are executed under standard legal arrangements (e.g., ISDA agreements) that establish key terms and conditions and often provide for netting among the counterparties in certain situations. In such cases, the “master” arrangement typically serves as an umbrella governing each executed derivative, and it is therefore necessary to look to the master arrangement for contingent features. In these situations, the features within the master arrangement would be ascribed to the individual contracts covered by the arrangement. In other cases, a derivative contract may be a stand-alone legal instrument and any related contingent features would reside within the derivative contract itself.
- The feature must be objective. More specifically, the feature must reference one or more specific contingent events and describe what the specific payment terms would be if the contingent event were to occur. For example, a feature requiring an entity to post $XX or XX percent of contract value with the counterparty if the entity’s credit rating drops below investment grade would be considered an objective feature. Material adverse-change clauses may or may not be objective. “General adequate assurance”1 clauses, which give each party in an arrangement the right to seek additional collateral if deemed necessary (but not on the basis of a specified credit event) are not considered objective, although entities are encouraged to provide supplemental disclosure about the existence of these types of provisions.
- The feature should be directly related to credit events or measures of creditworthiness. Collateral requirements that are based solely on either (1) market indexes (e.g., interest rates or commodity prices) or (2) the fair value of a derivative or a portfolio would generally not be considered credit-risk-related contingent features since they are not driven by discrete credit events. Likewise, although many operational events affect credit, contingencies driven by operations generally are not considered credit-risk-related contingent features. Accordingly, events such as a decline in revenues or a loss of a major customer would not be considered credit-risk-related contingent features that must be disclosed under ASC 815-10-50-4H. However, contingencies that are based on an entity’s failure to maintain specified liquidity ratios (e.g., current ratios or quick ratios) or financial leverage ratios (e.g., debt ratios or debt-to-equity ratios) would generally be considered credit-risk-related contingent features.
- Default provisions do not constitute credit-risk-related contingent features. Default provisions are triggered by an entity’s failure to perform under a particular contract. Contingent features, on the other hand, are generally related to factors or events that are external to the contract (e.g., a decline in a credit rating or a failure to maintain a minimum current ratio) and require incremental performance (e.g., posting of collateral) by one party or the other. Although some default events are ostensibly credit-driven, it is not necessary to identify credit-specific default provisions (e.g., payment delinquency or deficiency) and treat those events as credit-risk-related contingent features.
- Cross-default provisions require special consideration. Unlike the default provisions discussed in guideline 5 above, cross-default provisions are related to factors that are external to an entity’s performance under the contract in question; accordingly, an entity must carefully consider the terms and conditions of such provisions to determine whether they are within the scope of ASC 815-10-50-4H. In some circumstances, a cross-default provision may constitute a credit-risk-related contingent feature (e.g., when a failure to make a required interest or principal payment on a debt instrument triggers a collateral call or early settlement of a derivative liability). In this case, the failure to make a required interest or principal payment could be viewed as a credit event. By contrast, a cross-default provision that is based on a failure to deliver goods under a commodity sales contract could be triggered by factors other than credit.
- Bankruptcy and liquidation events do not constitute credit-risk-related contingent features.2 If payment is required only upon bankruptcy or final liquidation of the company, those features would not be considered credit-risk-related contingent features that must be disclosed under ASC 815-10-50-4H.
The examples below illustrate the application of the
above guidelines to specific features that may exist in derivative
contracts.
Features That Would
Represent Credit-Risk-Related Contingent
Features
|
Features That Would Not
Represent Credit-Risk-Related Contingent
Features
|
---|---|
A requirement to post a
discrete amount of collateral upon the occurrence
of a credit rating downgrade. The discrete amount
could be expressed as either a dollar amount or a
percentage of the contract’s fair value.
|
A material adverse change
clause that allows an entity to seek “performance
assurance” in an amount determined in a
commercially reasonable manner if and when the
counterparty experiences a change in condition
(financial or otherwise) that can be reasonably
expected to impair the counterparty’s ability to
fulfill its obligations.
|
A requirement to post a
discrete amount of collateral if a defined
financial leverage ratio (e.g., debt-to-equity
ratio) falls below an established threshold. The
discrete amount could be expressed as either a
dollar amount or a percentage of the contract’s
fair value.
|
A requirement to settle a
contract immediately upon a company’s default
under the contract in question. This would include
any default event under the contract in question,
including failure to pay when payment is due.
|
A requirement to settle a
contract immediately upon the occurrence of a
credit rating downgrade.
|
A requirement to settle a
contract immediately upon the occurrence of a
bankruptcy or liquidation event.
|
A requirement to settle a
contract immediately if a defined financial
leverage ratio (e.g., debt-to-equity ratio) falls
below an established threshold.
|
A requirement to post a
discrete amount of collateral if sales in a given
quarter fall short of published projections.
|
7.5.3.1.1.4 Letters of Credit Are Not Collateral
The credit enhancement requirements in many derivatives can be
satisfied by traditional collateral or standby LCs. A typical LC is
issued by a financial institution and authorizes the beneficiary of
the LC to draw specified amounts of cash upon the occurrence of a
specified event (e.g., an event of default under the related
derivative by the posting party). Some contractual arrangements
require the posting of an LC with the counterparty at inception,
while others provide for ongoing collateral requirements that can be
satisfied by cash or LC and are triggered by events after inception
(e.g., the credit rating is downgraded or the fair value exposure
threshold is exceeded). In either case, the LC effectively
represents a “guarantee” from the issuing financial institution of
the payment obligations of the posting party. LCs represent a
backstop mechanism in case the posting party cannot pay and,
therefore, it is not necessarily expected that the LC beneficiary
will ever draw upon the LC. If the LC beneficiary does draw upon the
LC, the posting party has an obligation to repay the issuing
financial institution; in other words, the posting party continues
to have an obligation but the previous derivative obligation (to the
derivative counterparty) is replaced with a debt obligation (to the
issuing financial institution).
As described above, LCs are often provided or “posted” to derivative
counterparties in lieu of collateral. Many entities negotiate LC
facilities with financial institutions to provide ready access to
LCs to support derivative transactions. Such facilities generally
allow the entity to post LCs for the benefit of yet-to-be-identified
derivative counterparties in amounts determined by the issuing
entity and without incremental approval from the financial
institution after inception. These facilities require commitment
fees and function similarly to lines of credit in the sense that
they establish a borrowing or “posting” cap and provide for the
revolving use of available capacity under the arrangement for a
defined period.
Although paragraph A44 of the Background Information
and Basis for Conclusions of FASB Statement 161 refers to “immediate
payment” requirements to a counterparty, the fundamental purpose of
the disclosures is to highlight the liquidity risk associated with
derivatives. Liquidity risk is not solely a function of immediate
exposure; therefore, arrangements such as LCs that allow an entity
to delay its payment obligations under a derivative do not remove
the related derivatives from the scope of the ASC 815-10-50-4H
credit risk disclosures.
The above guidance applies regardless of whether unused LC capacity
creates the potential to use available LCs in lieu of collateral
upon the occurrence of a credit-risk-related contingency. While
available LCs do not affect the scope of the ASC 815-10-50-4H
disclosures, entities are encouraged to describe their ability to
use available capacity under LC facilities to satisfy collateral
calls when preparing disclosures under ASC 815-10-50-4H(d)–(f), and
it is important that entities highlight this ability so that they
can properly portray their true liquidity exposure related to
derivative liabilities. In connection with this disclosure, entities
should (1) indicate the remaining borrowing or posting capacity
under LC facilities, (2) describe the repayment terms if an LC is
drawn by the derivative counterparty and an obligation to the
issuing financial institution is created, and (3) consider the need
to provide cross-references to other footnote disclosures, such as
the debt footnote, in which LC information resides. In describing
unused LC capacity, entities should consider any factors that would
limit the use of such capacity to support derivative liabilities.
Such factors may include contractual or legal restrictions, other
financing needs, and management intent.
7.5.3.2 Liquidity Risk Disclosure Requirements
ASC 815-10
50-4H An entity that holds
or issues derivative instruments (or nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66) shall disclose all of
the following for every annual and interim reporting
period for which a statement of financial position
is presented:
-
The existence and nature of credit-risk-related contingent features
-
The circumstances in which credit-risk-related contingent features could be triggered in derivative instruments (or such nonderivative instruments) that are in a net liability position at the end of the reporting period
-
The aggregate fair value amounts of derivative instruments (or such nonderivative instruments) that contain credit-risk-related contingent features that are in a net liability position at the end of the reporting period
-
The aggregate fair value of assets that are already posted as collateral at the end of the reporting period
-
The aggregate fair value of additional assets that would be required to be posted as collateral if the credit-risk-related contingent features were triggered at the end of the reporting period
-
The aggregate fair value of assets needed to settle the instrument immediately if the credit-risk-related contingent features were triggered at the end of the reporting period.
Amounts required to be reported for nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66 shall be the carrying
value of the nonderivative hedging instrument, which
includes the adjustment for the foreign currency
transaction gain or loss on that instrument. Example
23 (see paragraph 815-10-55-185) illustrates a
credit-risk-related contingent feature
disclosure.
Once the population of derivative liabilities subject to the liquidity risk
disclosures required in ASC 815-10-50-4H is identified (see Section
7.5.3.1.1), the preparation of the disclosure is largely an
aggregation exercise. For example, the ASC 815-10-50-4H(a) and (b)
disclosures would describe the different types of credit-risk-related
contingent features that exist within the individual derivative liabilities
identified.
Likewise, under the ASC 815-10-50-4H(c) disclosure requirement, the fair
values of the individual derivative liabilities would be aggregated (without
consideration of offsetting collateral). Finally, under the ASC
815-10-50-4H(d)–(f) disclosures, an entity would aggregate (1) the
collateral already posted as of the reporting date for each of the
individual derivative liabilities and (2) the remaining liquidity exposure
of each individual derivative liability (if it is assumed that the
worst-case credit contingency for each individual derivative liability was
triggered as of the reporting date).
Example 23 in ASC 815-10-55-185, which is reproduced below, provides an
illustration of liquidity risk disclosures.
ASC 815-10
55-185 This Example
illustrates the disclosure of credit-risk-related
contingent features in derivative instruments as
required by paragraph 815-10-50-4H.
Contingent Features
Certain of the Entity’s
derivative instruments contain provisions that
require the Entity’s debt to maintain an investment
grade credit rating from each of the major credit
rating agencies. If the Entity’s debt were to fall
below investment grade, it would be in violation of
these provisions, and the counterparties to the
derivative instruments could request immediate
payment or demand immediate and ongoing full
overnight collateralization on derivative
instruments in net liability positions. The
aggregate fair value of all derivative instruments
with credit-risk-related contingent features that
are in a liability position on December 31, 2009, is
$XX million for which the Entity has posted
collateral of $X million in the normal course of
business. If the credit-risk-related contingent
features underlying these agreements were triggered
on December 31, 2009, the Entity would be required
to post an additional $XX million of collateral to
its counterparties.
7.5.3.2.1 Multiple Credit-Risk-Related Triggers
Some derivative contracts contain multiple credit-risk-related contingent
features. For example, a contract may require an entity to post
escalating amounts of collateral with the counterparty as the entity’s
credit rating deteriorates along a defined rating spectrum.
On the basis of discussions with the FASB staff, we understand that the
disclosure requirements in ASC 815-10-50-4H(d)–(f) are meant to provide
financial statement users with information about the entity’s potential
liquidity exposure under a “worst-case” credit scenario. The worst-case
exposure represents the maximum amount of additional collateral or
payment that would be required (beyond what has already been posted) if
the credit-risk-related contingent feature providing the greatest
liquidity exposure to the entity is triggered at the end of the
reporting period, regardless of the likelihood of the feature being
triggered.
Note that with respect to the disclosures in ASC 815-10-50-4H(d)–(f), the
worst-case credit scenario is based on the population of
credit-risk-related contingent features within a contract and would not
take into account the contract default or bankruptcy of the entity,
which is consistent with item 7 of step 3 in the evaluation of
credit-risk-related contingent features in Section 7.5.3.1.1.
The ASC 815-10-50-4H(d)–(f) disclosures represent an aggregation of the
liquidity exposures associated with each derivative liability on the
basis of the credit-risk-related contingent features specific to each
derivative. Likewise, the assessment of the worst-case credit exposure
is performed at the individual derivative level as opposed to being
based on the single contingency that would have the most significant
liquidity impact when applied across an entity’s entire derivative
portfolio.
The guidance expressed above applies equally to the ASC 815-10-50-4H(a)
and (b) disclosures. In other words, entities should focus their
discussion of the “existence and nature of credit-risk-related
contingent features” on those features that require the maximum amount
of additional collateral or payment (beyond what has already been
posted) for each individual derivative liability.
When multiple credit-risk-related contingent features exist within
individual derivative contracts, entities are encouraged to consider
supplemental disclosure to highlight the potential liquidity exposure
associated with each contingency. It is not necessary to ascribe
probabilities to the contingencies being triggered nor is it appropriate
to exclude contingencies on the basis of a belief that the likelihood of
their occurrence is remote.
7.5.3.2.2 Disclosure of Nonderivative Positions
The liquidity disclosures in ASC 815-10-50-4H are only required for
derivatives recognized at fair value on the balance sheet. However, an
entity is encouraged to disclose how contracts other than derivative
instruments affect its potential (or worst-case) liquidity exposure to
derivatives (i.e., whether the impact is an increased or decreased
liquidity exposure). For example, an entity may hold contracts subject
to the NPNS scope exception in ASC 815-10-15-13 or other accrual-based
contracts that are governed under the same master netting arrangement as
the derivative liability in question. If these contracts are in asset or
liability positions as of the end of the reporting period, they could
reduce or increase, respectively, the entity’s liquidity exposure, as
further illustrated in the examples below. By describing its entire
liquidity exposure (including how nonderivative instruments may affect
its worst-case liquidity exposure to derivatives), an entity is
providing financial statement users with more relevant information.
On the basis of discussions with the FASB staff, we understood that there
are two acceptable approaches (discussed below) to developing the ASC
815-10-50-4H(d)–(f) disclosures. An entity should apply its adopted
approach consistently to all its master netting arrangements and
consider disclosing its approach in the notes to the financial
statements.
7.5.3.2.2.1 Approach 1
Under Approach 1, an entity determines the potential collateral
requirement on the basis of the fair value (or other measure if
explicitly referred to in the derivative contract or master netting
arrangement) of the derivative liabilities disclosed under ASC
815-10-50-4H(c),3 offset only by derivative asset positions subject to the same
master netting arrangement. While this approach is acceptable, the
resulting disclosures often do not accurately reflect an entity’s
true liquidity exposure in situations in which negative credit
events occur and the master netting arrangement also considers the
effect of nonderivative positions in determining the amount of
collateral required. Under this approach, an entity would ignore
nonderivative positions (e.g., NPNS contracts, receivables, or
payables), whether additive or subtractive to potential posting or
payment requirements, when developing disclosures about its
worst-case liquidity exposure. This approach reflects the narrow
scope of ASC 815-10-50-4H (i.e., derivatives only).
To comply with the ASC 815-10-50-4H(d)–(f) disclosures, an entity
that follows Approach 1 will most likely need to allocate4 collateral posted under a master netting arrangement to
specific derivative liabilities.
7.5.3.2.2.2 Approach 2
Under Approach 2, when a master netting arrangement exists, an entity
determines its potential exposure on the basis of the contractual
relationship (i.e., all contracts subject to the master netting
arrangement) and the specific terms of the credit-risk-related
contingent features. Master netting arrangements often govern the
collateral posting requirements for a basket of positions between
counterparties, typically on the basis of a net exposure
calculation. Under this approach, an entity is encouraged to
consider the effect of master netting arrangements and the impact of
all positions under the arrangements (including derivative assets,
NPNS contracts, and other accrual positions) when developing the
disclosure of the entity’s worst-case liquidity exposure.
As described in more detail in the last example below, while the FASB
staff agrees that the full effects of master netting arrangements
should be reflected in the ASC 815-10-50-4H(d)–(f) disclosures, it
would not object to a disclosure that (1) considers potential
offsets to collateral postings or payment requirements (reductions
to liquidity exposure) that are driven by nonderivative asset
positions in master netting arrangements but (2) ignores potential
increases to an entity’s liquidity exposure (beyond the exposure
represented by the derivative liability itself) created by
nonderivative liabilities under the same master netting
arrangement.
Master netting arrangements could affect the amount of additional
collateral5 or payments that are required to be disclosed under ASC
815-10-50-4H(e) and (f) in a variety of ways, including the following:
-
Master netting arrangements could eliminate additional posting or payment requirements if the portfolio is flat or in an asset position to the reporting entity (in such a scenario, a credit-risk-related contingency, such as a credit downgrade, would not prompt a collateral call by the counterparty because the net relationship is an asset to the reporting entity). For example, consider the following positions comprising a relationship under a master netting arrangement as of the balance sheet date (from the perspective of the reporting entity):In this case, the entity would not be required to post any additional collateral because it has a net asset position with the counterparty. Therefore, the counterparty would have no right to ask for collateral (even in the event of a credit downgrade).
-
Master netting arrangements could reduce the amount of collateral that must be posted if the reporting entity has an offsetting net asset position with the counterparty when all positions other than derivative liabilities are taken into account. For example, consider the following positions comprising a relationship under a master netting arrangement as of the balance sheet date (from the perspective of the reporting entity):In this case, the most the counterparty could request is $75; therefore, this amount serves as a cap for the ASC 815-10-50-4H(d)–(f) disclosures. The additional posting requirement could be less than $75 depending on the specific credit features in the master netting arrangement (the worst-case objective feature could require posting of 50 percent of the relationship value, in which case the disclosed amount under this example would be $37.50).
-
Master netting arrangements could reduce the amount of collateral that must be posted if the reporting entity has already posted some collateral under the relationship. For example, consider the following positions comprising a relationship under a master netting arrangement as of the balance sheet date (from the perspective of the reporting entity):In this case, the most the counterparty could request is $75; therefore, this amount serves as a cap for the ASC 815-10-50-4H(d)–(f) disclosure. The $75 would then be reduced by any collateral already posted with the counterparty. Even though the $40 posted in this example is most likely related to both the derivative liabilities and NPNS liabilities, the master netting arrangement limits the amounts of additional collateral that could be required as of the balance sheet date to $35 (i.e., $75 – $40) and, accordingly, this amount reflects the entity’s true liquidity exposure. Therefore, $35 is presumed to be the amount required to be disclosed under ASC 815-10-50-4H(e) and (f) because it represents the worst-case exposure should the credit-risk-related contingent feature be triggered. The amount required to be disclosed under ASC 815-10-50-4H(e) and (f) could be less than $35 depending on the specific credit features in the master netting arrangement (the worst-case objective feature could require the posting of 50 percent of the relationship value, in which case the disclosed amount under this example would be $17.50).
-
Master netting arrangements could increase the amount of collateral that must be posted if the portfolio as a whole is a larger liability than the sum of the derivative liabilities (e.g., if the portfolio includes NPNS contracts that are out-of-the-money). This potential increase would not be a mandatory part of the disclosure (i.e., the increase is related to nonderivatives, so it is technically outside the scope of ASC 815). However, entities are encouraged to incorporate the effects of master netting arrangements since doing so (1) helps achieve symmetry (master netting arrangements could increase or decrease posting or payment requirements) and (2) more accurately reflects liquidity exposure if negative credit events occur. For example, consider the following positions comprising a relationship under a master netting arrangement as of the balance sheet date (from the perspective of the reporting entity):In this case, there is a recommended application and an acceptable one:
-
Recommended application — Because the reporting entity’s exposure to credit features is based on a basket of liabilities (including some nonderivatives), the disclosure should reflect the true worst-case scenario when the overall relationship governed by the master netting arrangement is taken into account. Accordingly, $120 is presumed to be the amount that must be disclosed under ASC 815-10-50-4H(e) and (f) because it represents the worst-case exposure should the credit-risk-related contingent feature be triggered. The amount required to be disclosed under ASC 815-10-50-4H(e) and (f) could be less than $120 depending on the specific credit features in the master netting arrangement (the worst-case objective feature could require posting of 50 percent of the relationship value, in which case the disclosed amount under this example would be $60).
-
Acceptable application — The reporting entity’s exposure to credit-risk-related contingent features is based only on its derivative positions. Accordingly, $70 is presumed to be the amount required to be disclosed under ASC 815-10-50-4H(e) and (f), which could be less than $70 depending on the specific credit features in the master netting arrangement (the worst-case objective feature could require posting of 50 percent of the relationship value, in which case the disclosed amount under this example would be $35).
-
7.5.4 Balance Sheet Offsetting Disclosures
ASC 815-10
50-7 A reporting entity’s
accounting policy to offset or not offset in accordance
with paragraph 815-10-45-6 shall be disclosed.
50-7A A reporting entity
also shall disclose the information required by
paragraphs 210-20-50-1 through 50-6 for all recognized
derivative instruments accounted for in accordance with
Topic 815, including bifurcated embedded derivatives,
which are either:
-
Offset in accordance with either Section 210-20-45 or Section 815-10-45
-
Subject to an enforceable master netting arrangement or similar agreement.
50-8 A reporting entity shall
disclose the amounts recognized at the end of each
reporting period for the right to reclaim cash
collateral or the obligation to return cash collateral
as follows:
-
A reporting entity that has made an accounting policy decision to offset fair value amounts shall separately disclose amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral that have been offset against net derivative positions in accordance with paragraph 815-10-45-5.
-
A reporting entity shall separately disclose amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral under master netting arrangements that have not been offset against net derivative instrument positions.
-
A reporting entity that has made an accounting policy decision to not offset fair value amounts shall separately disclose the amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral under master netting arrangements.
ASC 210-20
Offsetting of Derivatives, Repurchase Agreements, and
Securities Lending Transactions
50-1 The disclosure
requirements in paragraphs 210-20-50-2 through 50-5
apply to both of the following:
-
Subparagraph superseded by Accounting Standards Update No. 2013-01.
-
Subparagraph superseded by Accounting Standards Update No. 2013-01.
-
Recognized derivative instruments accounted for in accordance with Topic 815, including bifurcated embedded derivatives, repurchase agreements accounted for as collateralized borrowings and reverse repurchase agreements, and securities borrowing and securities lending transactions that are offset in accordance with either Section 210-20-45 or Section 815-10-45
-
Recognized derivative instruments accounted for in accordance with Topic 815, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either Section 210-20-45 or Section 815-10-45.
50-2 An entity shall
disclose information to enable users of its financial
statements to evaluate the effect or potential effect of
netting arrangements on its financial position for
recognized assets and liabilities within the scope of
the preceding paragraph. This includes the effect or
potential effect of rights of setoff associated with an
entity’s recognized assets and recognized liabilities
that are in the scope of the preceding paragraph.
50-3 To meet the objective
in the preceding paragraph, an entity shall disclose at
the end of the reporting period the following
quantitative information separately for assets and
liabilities that are within the scope of paragraph
210-20-50-1:
-
The gross amounts of those recognized assets and those recognized liabilities
-
The amounts offset in accordance with the guidance in Sections 210-20-45 and 815-10-45 to determine the net amounts presented in the statement of financial position
-
The net amounts presented in the statement of financial position
-
The amounts subject to an enforceable master netting arrangement or similar agreement not otherwise included in (b):
- The amounts related to recognized financial
instruments and other derivative instruments that
either:
-
Management makes an accounting policy election not to offset.
-
Do not meet some or all of the guidance in either Section 210-20-45 or Section 815-10-45.
-
- The amounts related to financial collateral (including cash collateral).
- The amounts related to recognized financial
instruments and other derivative instruments that
either:
-
The net amount after deducting the amounts in (d) from the amounts in (c).
50-4 The information
required by the preceding paragraph shall be presented
in a tabular format, separately for assets and
liabilities, unless another format is more appropriate.
The total amount disclosed in accordance with paragraph
210-20-50-3(d) for an instrument shall not exceed the
amount disclosed in accordance with paragraph
210-20-50-3(c) for that instrument.
50-5 An entity shall provide
a description of the rights of setoff associated with an
entity’s recognized assets and recognized liabilities
subject to an enforceable master netting arrangement or
similar agreement disclosed in accordance with paragraph
210-20-50-3(d), including the nature of those
rights.
50-6 If the information
required by paragraphs 210-20-50-1 through 50-5 is
disclosed in more than a single note to the financial
statements, an entity shall cross-reference between
those notes.
Under ASC 815-10-50-7A, if an entity has derivative instruments that are either
(1) offset in accordance with ASC 210-20-45 or (2) subject to a master netting
arrangement or similar arrangement, it is required to comply with the disclosure
requirements of ASC 210-20-50-1 through 50-6 (see above).
In addition, ASC 815-10-50-8 requires an entity to separately disclose the
amounts of any receivables and payables related to cash collateral under
derivative agreements that have been offset against net derivative positions in
accordance with ASC 815-10-45-5. If an entity has made an accounting policy
decision to not offset the receivables or payables related to cash collateral
under derivative agreements against the net derivative positions, it should
disclose the amount of those receivables and payables as well as its accounting
policy of not offsetting those amounts.
7.5.5 Credit Derivatives
ASC Master Glossary
Credit Derivative
A derivative instrument that has both of the following
characteristics:
- One or more of its underlyings are related to
any of the following:
- The credit risk of a specified entity (or a group of entities)
- An index based on the credit risk of a group of entities.
- It exposes the seller to potential loss from credit-risk-related events specified in the contract.
Examples of credit derivatives include, but are not
limited to, credit default swaps, credit spread options,
and credit index products.
ASC 815-10
50-4J For purposes of the
following paragraph, the term seller (sometimes referred
to as a writer of the contract) refers to the party that
assumes credit risk, which could be either:
-
A guarantor in a guarantee type contract
-
Any party that provides the credit protection in an option type contract, a credit default swap, or any other credit derivative contract.
50-4K A seller of credit
derivatives shall disclose information about its credit
derivatives and hybrid instruments (for example, a
credit-linked note) that have embedded credit
derivatives to enable users of financial statements to
assess their potential effect on its financial position,
financial performance, and cash flows. Specifically, for
each statement of financial position presented, the
seller of a credit derivative shall disclose all of the
following information for each credit derivative, or
each group of similar credit derivatives, even if the
likelihood of the seller’s having to make any payments
under the credit derivative is remote:
- The nature of the credit derivative, including
all of the following:
-
The approximate term of the credit derivative
-
The reason(s) for entering into the credit derivative
-
The events or circumstances that would require the seller to perform under the credit derivative
-
The current status (that is, as of the date of the statement of financial position) of the payment/performance risk of the credit derivative, which could be based on either recently issued external credit ratings or current internal groupings used by the seller to manage its risk
-
If the entity uses internal groupings for purposes of item (a)(4), how those groupings are determined and used for managing risk.
-
- All of the following information about the
maximum potential amount of future payments under
the credit derivative:
-
The maximum potential amount of future payments (undiscounted) that the seller could be required to make under the credit derivative, which shall not be reduced by the effect of any amounts that may possibly be recovered under recourse or collateralization provisions in the credit derivative (which are addressed in items (c) through (f))
-
The fact that the terms of the credit derivative provide for no limitation to the maximum potential future payments under the contract, if applicable
-
If the seller is unable to develop an estimate of the maximum potential amount of future payments under the credit derivative, the reasons why it cannot estimate the maximum potential amount.
-
- The fair value of the credit derivative as of the date of the statement of financial position
- The nature of any recourse provisions that would enable the seller to recover from third parties any of the amounts paid under the credit derivative
- The nature of any assets held either as collateral or by third parties that, upon the occurrence of any specified triggering event or condition under the credit derivative, the seller can obtain and liquidate to recover all or a portion of the amounts paid under the credit derivative
- If estimable, the approximate extent to which the proceeds from liquidation of assets held either as collateral or by third parties would be expected to cover the maximum potential amount of future payments under the credit derivative. In its estimate of potential recoveries, the seller of credit protection shall consider the effect of any purchased credit protection with identical underlying(s).
However, the disclosures required by this paragraph do
not apply to an embedded derivative feature related to
the transfer of credit risk that is only in the form of
subordination of one financial instrument to another, as
described in paragraph 815-15-15-9.
50-4L One way to present the
information required by the preceding paragraph for
groups of similar credit derivatives would be first to
segregate the disclosures by major types of contracts
(for example, single-name credit default swaps, traded
indexes, other portfolio products, and swaptions) and
then, for each major type, provide additional subgroups
for major types of referenced (or underlying) asset
classes (for example, corporate debt, sovereign debt,
and structured finance). With respect to hybrid
instruments that have embedded credit derivatives, the
seller of the embedded credit derivative shall disclose
the information required by the preceding paragraph for
the entire hybrid instrument, not just the embedded
credit derivatives.
Additional disclosures for entities that write credit derivatives are applicable
under ASC 815-10-50-4J through 50-4L. For information about the disclosure
requirements related to fair value measurements, see Deloitte’s Roadmap
Fair Value
Measurements and Disclosures (Including the Fair Value
Option).
7.5.6 Accounting Policies Regarding Derivatives
An entity’s disclosures related to derivatives (other than derivatives related to
hedging activities) should include the following accounting policy decisions, if
they are significant:
-
Whether the entity has offset the derivatives with the fair value amounts recognized for receivables and payables related to those derivatives in accordance with ASC 815-10-45-5.
-
The cash flow statement classification of derivatives.
-
The accounting for the premium paid (time value) to acquire an option that is classified as HTM or AFS (see ASC 815-10-50-9).
7.5.7 Additional Required Disclosures
Other disclosures may be required by U.S. GAAP or SEC rules and regulations. For
example, ASC 825-10-50-20 and 50-21 require disclosures about the concentrations
of credit risk of all financial instruments, including derivative instruments.
In addition, SEC registrants should refer to the disclosure requirements in SEC
Regulation S-X, Rule 4-08(n). Registrants also must comply with the requirements
of SEC Regulation S-K, Item 305, in the MD&A section of certain SEC filings.
7.5.8 Convertible Debt Considerations
ASC 470-20
50-1I An entity shall
disclose the following information about derivative
transactions entered into in connection with the
issuance of convertible debt instruments within the
scope of this Subtopic regardless of whether such
derivative transactions are accounted for as assets,
liabilities, or equity instruments:
-
The terms of those derivative transactions (including the terms of settlement)
-
How those derivative transactions relate to the instruments within the scope of this Subtopic
-
The number of shares underlying the derivative transactions
-
The reasons for entering into those derivative transactions.
An example of a derivative transaction entered into in
connection with the issuance of a convertible debt
instrument within the scope of this Subtopic is the
purchase of call options that are expected to
substantially offset changes in the fair value or the
potential dilutive effect of the conversion option.
Derivative instruments also are subject to the
disclosure guidance in Topic 815.
Additional disclosure requirements are applicable for derivative transactions
that are entered into in connection with the issuance of convertible debt. For
example, entities may simultaneously issue convertible debt and a capped call
that limits the potential dilution that would result if and when the convertible
debt instrument is settled in the entity’s stock. In such cases, they should
follow the guidance in ASC 470-20-50-1I. For further details on accounting for
convertible debt instruments, see Deloitte’s Roadmap Issuer’s Accounting for
Debt.
7.5.9 Disclosure Matters Related to Hybrid Financial Instruments
7.5.9.1 Embedded Conversion Option That Is No Longer Bifurcated
ASC 815-15
50-3 An issuer shall
disclose both of the following for the period in
which an embedded conversion option previously
accounted for as a derivative instrument under this
Subtopic no longer meets the separation criteria
under this Subtopic:
-
A description of the principal changes causing the embedded conversion option to no longer require bifurcation under this Subtopic
-
The amount of the liability for the conversion option reclassified to stockholders’ equity.
ASC 815-40
50-3 Contracts within the
scope of this Subtopic may be required to be
reclassified into (or out of) equity during the life
of the instrument (in whole or in part) pursuant to
the provisions of paragraphs 815-40-35-8 through
35-13. An issuer shall disclose contract
reclassifications (including partial
reclassifications), the reason for the
reclassification, and the effect on the issuer’s
financial statements.
If a previously bifurcated embedded conversion option in a hybrid instrument
ceases to meet the ASC 815-15 bifurcation criteria, the entity should
provide the disclosures required by ASC 815-15-50-3 and ASC 815-40-50-3, as
noted above. For further details on the circumstances that could cause a
hybrid instrument to no longer meet the bifurcation criteria, see Section 6.4
of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity.
7.5.9.2 Inability to Reliably Identify and Measure Embedded Derivative Hybrid Financial Instruments
As indicated in ASC 815-30-35-2, in the unusual situation in which an entity
cannot reliably identify and measure an embedded feature that is required to
be separated as a derivative, the entity must record the entire hybrid
instrument at fair value and recognize changes in fair value through
earnings. In practice, this provision is rarely applied. Note that under no
circumstance can such an instrument be designated as a hedging instrument
under ASC 815-20.
ASC 815-15
45-1 In each statement of
financial position presented, an entity shall report
hybrid financial instruments measured at fair value
under the election and under the practicability
exception in paragraph 815-15-30-1 in a manner that
separates those reported fair values from the
carrying amounts of assets and liabilities
subsequently measured using another measurement
attribute on the face of the statement of financial
position. To accomplish that separate reporting, an
entity may do either of the following:
-
Display separate line items for the fair value and non-fair-value carrying amounts
-
Present the aggregate of the fair value and non-fair-value amounts and parenthetically disclose the amount of fair value included in the aggregate amount.
As noted above, under ASC 815-15-45-1, if an entity accounts for a hybrid
financial instrument at fair value because it cannot reliably identify and
measure an embedded derivative, it must report the related fair value
amounts separately on the face of the balance sheet under ASC 815-15-45-1.
ASC 815-15
50-1 For those hybrid
financial instruments measured at fair value under
the election and under the practicability exception
in paragraph 815-15-30-1, an entity shall also
disclose the information specified in paragraphs
825-10-50-28 through 50-32.
50-2 An entity shall
provide information that will allow users to
understand the effect of changes in the fair value
of hybrid financial instruments measured at fair
value under the election and under the
practicability exception in paragraph 815-15-30-1 on
earnings (or other performance indicators for
entities that do not report earnings).
If an entity accounts for a hybrid financial instrument at fair value because
it cannot reliably identify and measure an embedded derivative, it must also
provide the required disclosures for financial liabilities for which the
fair value option in ASC 825-10 has been elected. For further detail on such
disclosures, see Section 14.4.11 of Deloitte’s Roadmap Issuer’s Accounting
for Debt.
Footnotes
1
For example, some contracts give entities the ability
to seek “performance assurance” in an amount
determined in a commercially reasonable manner if
and when the counterparty experiences a change in
condition (financial or otherwise) that can be
reasonably expected to impair the counterparty’s
ability to fulfill its obligations. These clauses do
not cite specific trigger events (e.g., downgrade
events) and do not prescribe specific dollar amounts
or percentages of contract value that must be posted
as performance assurance.
2
This guidance addresses disclosure requirements under
ASC 815. If there is substantial doubt about an
entity’s ability to continue as a going concern, the
entity would most likely be required to provide
additional disclosures, including disclosures that
indicate the consequences of bankruptcy or
liquidation. Going-concern considerations are beyond
the scope of this guidance.
3
ASC 815-10-50-4H(c) requires entities to disclose the
“aggregate fair value amounts of derivative instruments . .
. that contain credit-risk-related contingent features that
are in a net liability position at the end of the reporting
period.”
4
When determining amounts already posted, an entity may need
to allocate posted collateral among derivative and
nonderivative positions (e.g., if collateral is posted for a
net relationship liability under a master netting
arrangement and the relationship consists of derivatives and
nonderivatives). Allocation approaches should be reasonable
and consistently applied. For guidance on allocation methods
under ASC 815-10-45-1 through 45-7 and ASC 210-20-45-1
through 45-5, see Section
7.2.1.1.5).
5
For simplicity, it is assumed in the examples below that
collateral requirements are calculated by reference to the
GAAP fair value of the contract (or the portfolio when
master netting arrangements are considered) as of the
balance sheet date. If contracts (or master netting
arrangements) require posting of collateral on a different
basis, an entity should use the basis prescribed in the
contract to develop the disclosures under ASC
815-10-50-4H(d)–(f). It is also assumed in the examples that
the most a counterparty can request is 100 percent
collateralization.
Chapter 8 — Comparison of U.S. GAAP and IFRS Accounting Standards
Chapter 8 — Comparison of U.S. GAAP and IFRS Accounting Standards
8.1 Background
Under U.S. GAAP, the primary sources of guidance on derivative
instruments are ASC 815-10, ASC 815-15, and ASC 815-40. Under IFRS Accounting
Standards, the primary sources of such guidance are IFRS 9 and IAS 32. The
foundational concepts related to derivatives are similar in the two sets of
standards. For example, both standards require derivatives to be accounted for at
fair value, with changes in fair value recorded through earnings, unless the
contract is designated as part of a hedging relationship. However, the definition of
a derivative is narrower under U.S. GAAP than it is under IFRS Accounting Standards
and, as a result, more instruments may meet the definition under IFRS Accounting
Standards.
8.2 Key Differences
The table below summarizes key differences between U.S. GAAP and
IFRS Accounting Standards related to derivatives.
Topic
|
U.S. GAAP (ASC 815)
|
IFRS Accounting Standards (IFRS 9, IAS 32)
|
---|---|---|
Derivative — definition
|
For an instrument to meet the definition of a derivative, the
following characteristics must be present:
|
For an instrument to meet the definition of a derivative, the
following characteristics must be present:
Though the definition of a derivative under IFRS Accounting
Standards does not include a net settlement characteristic,
contracts to purchase or sell nonfinancial items are within
the scope of IFRS 9 only if they can be settled net.
|
Derivatives — scope
|
The NPNS scope exception for qualifying contracts to purchase
or sell nonfinancial items is elective and requires the
designation to be documented.
|
While both IFRS Accounting Standards and U.S. GAAP provide
scope exceptions for certain contracts to purchase or sell
nonfinancial items that will be purchased, sold, or used in
the normal course of business, under IFRS Accounting
Standards, the own-use scope exception for qualifying
contracts is not elective (unless applying the own-use scope
exception leads to an accounting mismatch) and does not
require an entity to document its designation of a contract
as “own-use.”
|
Embedded derivatives — initial recognition
|
The bifurcation requirements apply to both assets and
liabilities, including financial assets.
In addition, the application guidance under U.S. GAAP is more
detailed than that under IFRS Accounting Standards.
Accordingly, an entity may not necessarily reach the same
conclusion under IFRS Accounting Standards as under U.S.
GAAP about whether the conditions for bifurcation are
met.
|
While the overall criteria for bifurcation are similar to
those under U.S. GAAP, the bifurcation requirements do not
apply to financial assets within the scope of IFRS 9.
Therefore, if a hybrid contract contains a host that is a
financial asset within the scope of IFRS 9, the bifurcation
requirements do not apply.
|
Embedded derivatives — debt with embedded put or call
option
|
A put, call, or prepayment option embedded in a debt contract
is considered not clearly and closely related to a debt host
contract if (1) it is indexed to an underlying other than
interest rates, credit risk, or inflation; (2) the debt
involves a substantial discount or premium and the option is
contingent; or (3) the option is not contingent and the
negative-yield or double-double test is passed.
|
A put, call, or prepayment option embedded in a debt contract
is not considered closely related to a debt host contract
unless (1) the exercise price is approximately equal on each
exercise date to the debt host contract’s amortized cost
(before the separation of any equity component) or (2) the
exercise price results in reimbursement to the lender for an
amount up to the approximate present value of lost interest
for the remaining term.
|
Embedded equity components in a debt contract — initial
recognition
|
Embedded equity-linked features that qualify as equity are
not separated from liabilities (e.g., convertible debt)
except in the specific circumstances listed below:
|
Embedded equity-linked features that qualify as equity are
separated from liabilities and accounted for as equity.
|
Embedded equity components — initial measurement
|
Different methods apply for initial measurement of equity
components depending on the reason an amount is allocated to
equity.
|
The with-and-without method is used for initial measurement
of equity components. The liability component is measured
first.
|
Contracts with payments indexed to revenue
|
ASC 815-10-15-59(d) provides a scope exception for
non-exchange-traded contracts in which the underlying is
based on specified volumes of sales or service revenues of
one of the parties to the contract.
|
Contracts with an underlying based on sales volumes are
subject to IFRS 9 accounting as derivatives or embedded
derivatives, as applicable, unless (1) they are subject to a
scope exception or (2) the only underlying is a variable
that is specific to one party to the contract.
|
Appendix A — Titles of Standards and Other Literature
Appendix A — Titles of Standards and Other Literature
AICPA Literature
Audit and Accounting Guide
Brokers and Dealers in Securities
FASB Literature
ASC Topics
ASC 210, Balance Sheet
ASC 310, Receivables
ASC 320, Investments — Debt Securities
ASC 321, Investments — Equity Securities
ASC 325, Investments — Other
ASC 326, Financial Instruments — Credit Losses
ASC 405, Liabilities
ASC 450, Contingencies
ASC 460, Guarantees
ASC 470, Debt
ASC 480, Distinguishing Liabilities From Equity
ASC 606, Revenue From Contracts With Customers
ASC 718, Compensation — Stock Compensation
ASC 815, Derivatives and Hedging
ASC 820, Fair Value Measurement
ASC 825, Financial Instruments
ASC 830, Foreign Currency Matters
ASC 840, Leases
ASC 842, Leases
ASC 850, Related Party Disclosure
ASC 860, Transfers and Servicing
ASC 924, Entertainment — Casino
ASC 940, Financial Services — Brokers and Dealers
ASC 942, Financial Services — Depository and Lending
ASC 944, Financial Services — Insurance
ASC 946, Financial Services — Investment Companies
ASC 948, Financial Services — Mortgage Banking
ASC 954, Health Care Entities
ASC 960, Plan Accounting — Defined Benefit Pension Plans
ASC 962, Plan Accounting — Defined Contribution Pension Plans
ASC 965, Plan Accounting — Health and Welfare Benefit Plans
ASUs
ASU 2013-01, Balance Sheet (Topic 210): Clarifying the Scope of
Disclosures about Offsetting Assets and Liabilities
ASU 2016-02, Leases (Topic 842)
ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to
Accounting for Hedging Activities
ASU 2018-09, Codification Improvements
ASU 2018-12, Financial Services — Insurance (Topic 944): Targeted
Improvements to the Accounting for Long-Duration Contracts
ASU 2020-06, Debt — Debt With Conversion and Other Options (Subtopic
470-20) and Derivatives and Hedging — Contracts in Entity’s Own Equity
(Subtopic 815-40): Accounting for Convertible Instruments and Contracts
in an Entity’s Own Equity
Concepts Statement
No. 5, Recognition and Measurement in Financial Statements of Business
Enterprises
IFRS Literature
IFRS 9, Financial Instruments
IAS 32, Financial Instruments: Presentation
SEC Literature
Final Rule Release
No. 34-96930, Shortening the Securities Transaction Settlement Cycle
Regulation S-K
Item 305, “Quantitative and Qualitative Disclosures About Market Risk”
Regulation S-X
Rule 4-08(n), “General Notes to Financial Statements; Accounting Policies for
Certain Derivative Instruments”
SAB Topic
No. 5.DD, “Miscellaneous Accounting; Written Loan Commitments Recorded at
Fair Value Through Earnings”
Securities Act of 1933
Rule 144, “Persons Deemed Not to Be Engaged in a Distribution and Therefore
Not Underwriters”
Rule 144A, “Private Resales of Securities to Institutions”
Securities Exchange Act of 1934
Section 13, “Periodical and Other Reports”
Section 15(d), “Registration and Regulation of Brokers and Dealers;
Supplementary and Periodic Information”
Superseded Literature
Derivatives Implementation Group (DIG) Issue
F6, “Fair Value Hedges: Concurrent Offsetting Matching Swaps and Use of One
as Hedging Instrument”
EITF Abstract
Issue No. 02-2, “When Certain Contracts That Meet the Definition of Financial
Instruments Should Be Combined for Accounting Purposes”
FASB Concepts Statement
No. 6, Elements of Financial Statements
FASB Staff Position (FSP)
No. FIN 39-1, Amendment of FASB Interpretation No. 39
FASB Statements
No. 133, Accounting for Derivative Instruments and Hedging
Activities
No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities
No. 155, Accounting for Certain Hybrid Financial Instruments — an
amendment of FASB Statements No. 133 and 140
No. 159, The Fair Value Option for Financial Assets and Financial
Liabilities
No. 161, Disclosures About Derivative Instruments and Hedging
Activities
Appendix B — Abbreviations
Appendix B — Abbreviations
Abbreviation
|
Description
|
---|---|
AFS
|
available for sale
|
AICPA
|
American Institute of Certified Public Accountants
|
ASC
|
FASB Accounting Standards Codification
|
ASU
|
FASB Accounting Standards Update
|
CAD
|
Canadian dollar
|
CAQ
|
Center for Audit Quality
|
CPI
|
consumer price index
|
CUSIP
|
Committee on Uniform Security Identification Procedures
|
DIG
|
FASB Derivatives Implementation Group
|
EBITDA
|
earnings before interest, taxes, depreciation, and
amortization
|
EITF
|
FASB Emerging Issues Task Force
|
ESG
|
environmental, social, and governance
|
FASB
|
Financial Accounting Standards Board
|
FHLMC
|
Federal Home Loan Mortgage Corporation
|
FIN
|
FASB Interpretation Number
|
FNMA
|
Federal National Mortgage Association
|
FSP
|
FASB Staff Position
|
GAAP
|
generally accepted accounting principles
|
GNMA
|
Government National Mortgage Association
|
HTM
|
held to maturity
|
IAS
|
International Accounting Standard
|
IFRS
|
International Financial Reporting Standard
|
IO
|
interest only
|
IPO
|
initial public offering
|
ISDA
|
International Swaps and Derivatives Association
|
JPY
|
Japanese yen
|
LC
|
letter of credit
|
LIBOR
|
London Interbank Offered Rate
|
MBS
|
mortgage-backed security
|
MD&A
|
Management’s Discussion and Analysis
|
MXN
|
Mexican peso
|
Nasdaq
|
National Association of Securities Dealers Automated
Quotations
|
NEPOOL
|
New England Power Pool
|
NFP
|
not-for-profit entity
|
NPNS
|
normal purchase and normal sale
|
NYMEX
|
New York Mercantile Exchange
|
NYSE
|
New York Stock Exchange
|
OCA
|
SEC Office of the Chief Accountant
|
OCI
|
other comprehensive income
|
PCAOB
|
Public Company Accounting Oversight Board
|
PIK
|
paid in kind
|
PJM
|
Pennsylvania, New Jersey, Maryland
|
PO
|
principal only
|
QIB
|
qualified institutional buyer
|
RCC
|
readily convertible to cash
|
R&D
|
research and development
|
RSA
|
revenue-sharing agreement
|
SEC
|
U.S. Securities and Exchange Commission
|
S&P
|
Standard and Poor
|
SOFR
|
Secured Overnight Financing Rate
|
SPA
|
share purchase agreement
|
SPE
|
special-purpose entity
|
TIPS
|
Treasury inflation-protected security
|
USD
|
U.S. dollar
|
VEB
|
Venezuelan bolivar
|