2.2 Derivative Instruments

2.2.1 Interaction With the Derivative Accounting Requirements

ASC 815-40

15-4 The guidance in this Subtopic applies to derivatives embedded in contracts in analyzing the embedded feature under paragraphs 815-15-25-1(c) and 815-15-25-14 as though it were a freestanding instrument (as further discussed in paragraphs 815-40-25-39 through 25-40).

15-5 The guidance in this paragraph through paragraph 815-40-15-8 applies to any freestanding financial instrument or embedded feature that has all the characteristics of a derivative instrument (see the guidance beginning in paragraph 815-10-15-83). That guidance applies for the purpose of determining whether that instrument or embedded feature qualifies for the first part of the scope exception in paragraph 815-10-15-74(a). That guidance does not address the second part of the scope exception in paragraph 815-10-15-74(a), which is addressed in Section 815-40-25. The guidance also applies to any freestanding financial instrument that is potentially settled in an entity’s own stock, regardless of whether the instrument has all the characteristics of a derivative instrument for purposes of determining whether the instrument is within the scope of this Subtopic.

15-9 For guidance on the interaction of this Subtopic and Subtopic 815-10, see paragraphs 815-10-15-74 through 15-78. For guidance on the interaction of this Subtopic and Subtopic 815-15, see paragraph 815-15-25-15.

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:
1. Indexed to its own stock (see Section 815-40-15)
2. Classified in stockholders’ equity in its statement of financial position (see Section 815-40-25). . . .

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.

15-83 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:
1. One or more underlyings
2. 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:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Some freestanding equity-linked instruments have the characteristics of a derivative instrument under ASC 815-10-15-83. In accordance with ASC 815, such instruments must be accounted for as derivatives at fair value, with changes in fair value reported in earnings, unless they meet a scope exception in ASC 815.1 Under ASC 815-10-15-74(a), certain contracts on an entity’s own equity are exempt from derivative accounting. In assessing whether an equity-linked instrument qualifies for this scope exception, an entity applies the indexation and equity classification guidance in ASC 815-40. A contract that qualifies as equity under the indexation and equity classification guidance in ASC 815-40 would meet that scope exception and therefore would be exempt from the derivative accounting requirements in ASC 815.

A freestanding equity-linked instrument that does not meet the definition of a derivative instrument is outside the scope of ASC 815 but is nevertheless within the scope of ASC 815-40. For example, a freestanding warrant that requires physical settlement in private-company stock may not meet the net settlement characteristic in the definition of a derivative instrument. The issuer of a warrant that does not meet the definition of a derivative instrument would assess it under ASC 815-40 but not under ASC 815. If the instrument does not meet the indexation and equity classification guidance in ASC 815-40, it must be classified as an asset or liability and recognized at fair value, with changes in fair value reported in earnings. This accounting is required even though the instrument does not have all the characteristics of a derivative instrument in ASC 815-10-15-83.

Connecting the Dots

Because ASC 815-40 must be applied to all freestanding equity-linked instruments, the classification and measurement of such instruments is the same irrespective of whether they meet the characteristics of a derivative instrument in ASC 815-10-15-83. However, if an equity-linked instrument does not qualify for equity classification, the disclosures in ASC 815 apply only if the instrument meets the definition of a derivative instrument.

2.2.2 Hybrid Instruments and Embedded Features

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.)

ASC 815-40

An entity may issue a hybrid nonderivative instrument that contains an embedded equity-linked instrument (e.g., convertible securities or redeemable equity securities). Although the guidance in ASC 815-40 does not directly address hybrid financial instruments, its requirements related to indexation and equity classification may apply in the determination of whether the embedded feature must be bifurcated under ASC 815-15-25-1. Bifurcation of an embedded feature is required if the three conditions in ASC 815-15-25-1 are met. If the first two conditions in ASC 815-15-25-1 are met, the entity must determine whether the embedded feature qualifies as a derivative instrument on a stand-alone basis (i.e., under ASC 815-15-25-1(c)).

An embedded feature that does not contain all the characteristics of a derivative instrument in ASC 815-10-15-83 does not meet the third condition in ASC 815-15-25-1; therefore, bifurcation of the feature is not required, and the entity does not need to evaluate the embedded feature under the indexation and equity classification guidance in ASC 815-40. However, if the embedded feature does meet all the characteristics of a derivative instrument in ASC 815-10-15-83, the entity must evaluate whether the feature is eligible for the scope exception in ASC 815-10-15-74(a).2 To do so, the entity applies the indexation and equity classification guidance in ASC 815-40. An embedded feature that does not qualify as equity under ASC 815-40 and meets the three bifurcation conditions in ASC 815-15-25-1 is removed from its host contract and accounted for separately as a derivative instrument. If the feature meets the indexation and equity classification requirements, however, it is not bifurcated because the exception in ASC 815-10-15-74(a) applies.

Connecting the Dots

ASC 815-40 only applies to an embedded feature in the determination of whether it qualifies for the scope exception in ASC 815-10-15-74(a). The recognition, measurement, and disclosure guidance in ASC 815-40 does not apply to an embedded feature irrespective of whether the feature has all the characteristics of a derivative instrument in ASC 815.3 Instead, the embedded feature is subject to the recognition, measurement, and disclosure guidance in ASC 470-20, ASC 505-10, and ASC 815.

Under ASC 480-10-S99-3A and other SEC guidance, registrants are required to classify certain redeemable equity securities in temporary equity outside of permanent equity. (For a comprehensive discussion of the application of this guidance, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.) In the evaluation of whether an item meets the scope exception for an entity’s own equity in ASC 815-10-15-74(a), temporary equity is considered equity (ASC 815-10-15-76).

Connecting the Dots

ASC 815-10-15-76 indicates that in the evaluation of whether an item meets the scope exception in ASC 815-10-15-74(a) for an entity’s own equity, temporary equity is considered equity. This guidance is relevant to the evaluation of embedded derivatives in a hybrid contract; however, it is not relevant to the evaluation of a freestanding equity-linked instrument. As noted in the example below, the guidance in ASC 815-10-15-76 is relevant to the evaluation of a put option embedded in a share because the share (host contract) would be classified in temporary equity as a result of the embedded equity-linked instrument. However, this guidance does not permit a freestanding option on a redeemable equity security (i.e., an equity security that is redeemable for cash) to meet the equity classification requirements in ASC 815-40-25. Rather, such an equity-linked instrument would be considered a net-cash-settled instrument that does not qualify for equity classification under ASC 815-40-25.

Example 2-1

Scope Exception — Temporary Equity

An SEC registrant issues shares that contain an embedded written put option that permits the holder to put the shares back to the registrant in exchange for a cash payment. In accordance with ASC 480-10-S99-3A, the registrant may be required to classify the shares in temporary equity. When evaluating whether the embedded put option qualifies for the scope exception in ASC 815-10-15-74(a) under the equity classification guidance in ASC 815-40 (e.g., in assessing whether the contract permits the issuer to settle in shares), the registrant would consider the shares to be equity shares even though they are presented outside of permanent equity.

A feature that is commonly subject to evaluation under ASC 815-40 is an equity conversion option embedded in a debt instrument. If it meets all the characteristics of a derivative instrument in ASC 815-10-15-83, such feature must be bifurcated under ASC 815-15 unless either of the following apply:

The convertible debt instrument is recognized at fair value, with changes in fair value reported in earnings (e.g., the issuer has elected the fair value option in ASC 825-10).
The embedded conversion option meets the indexation and equity classification guidance in ASC 815-40. (Note that features embedded in certain convertible debt instruments are exempt from some of the equity classification conditions in ASC 815-40-25 [see Section 5.5].)

Example 2-2

Embedded Derivatives

An entity has issued a debt security that gives the counterparty the right to convert the security into the entity’s common stock. The equity conversion feature (1) meets all the characteristics of a derivative in ASC 815-10-15-83 (e.g., because the stock is publicly traded and the number of shares received upon conversion can be rapidly absorbed by the market) and (2) otherwise meets the conditions for separation as an embedded derivative in ASC 815-15-25-1 (e.g., it is not clearly and closely related to its host debt contract, and the debt is not being remeasured at fair value with changes in fair value recognized in earnings). The entity would assess the conversion feature under the indexation and equity classification guidance in ASC 815-40 to determine whether the scope exception to the derivative accounting guidance in ASC 815-10-15-74(a) applies. If the conversion feature qualifies as equity under ASC 815-40, it would be exempt from derivative accounting. If it does not qualify as equity under ASC 815-40, it would be bifurcated as a derivative instrument under ASC 815-15 unless another scope exception applies.

Connecting the Dots

For further discussion of the issuer’s accounting for equity conversion features embedded in debt instruments, see Deloitte’s Roadmap Issuer’s Accounting for Debt.

Footnotes

While ASC 815 requires certain changes in the fair value of derivative instruments designated in qualifying cash flow hedges to be recognized in other comprehensive income, ASC 815-20-25-15(h) does not permit an entity to designate a transaction involving the entity’s own equity instruments as a hedged item in a cash flow hedge.

This evaluation would be unnecessary if the embedded feature met another exception to the derivative accounting guidance in ASC 815-10 or ASC 815-15. However, in practice, embedded equity-linked instruments generally only potentially qualify for the scope exception in ASC 815-10-15-74(a).

ASC 815-40 does, however, apply to the evaluation of whether an embedded feature that meets the definition of a derivative instrument qualifies for the scope exception in ASC 815-10-15-74(a) (see ASC 815-40-15-4).

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