6.4 Embedded Features
While ASC 815-40 applies in the determination of whether an embedded feature qualifies as equity, it does not address the recognition, measurement, and presentation of a feature embedded in another contract (e.g., an equity conversion option embedded in a debt security or in a preferred stock instrument).
Under ASC 815-15-25-1, an entity is required to bifurcate — that is, separately account for — a feature embedded within another contract when the following three conditions are met:
- The hybrid instrument (i.e., the combination of the embedded feature and its host contract) is not being measured at fair value with changes in fair value recorded immediately through earnings.
- 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 the definition of a derivative in ASC 815-10 and the scope exceptions from derivative accounting in ASC 815-10 and ASC 815-15.
- The economic characteristics and risks of the embedded feature are not clearly and closely related to those of the host contract (e.g., an embedded feature with characteristics and risks of equity would not be considered clearly and closely related to a debt host contract).
If the feature is required to be separated under ASC 815-15, the feature is recognized as a derivative asset or liability and measured at fair value with changes in fair value recognized in earnings. For example, an equity conversion feature embedded in a debt security would be separated from its host contract and accounted for as a derivative if the feature does not qualify as equity under ASC 815-40 and the shares to be delivered are readily convertible to cash.
If the embedded feature qualifies as equity under ASC 815-40 or does not
otherwise have to be separated as an embedded derivative, it is excluded from the
scope of the derivative accounting guidance in ASC 815-10 and ASC 815-15 in
accordance with ASC 815-10-15-74(a). For such a feature, the entity should consider
whether other accounting guidance applies.
The determination of whether an embedded feature qualifies as equity is
reassessed in each period unless reassessment is unnecessary because the feature
does not meet the other criteria for bifurcation in ASC 815-15-25-1. If an embedded
feature ceases to meet the conditions in ASC 815-40 for equity classification after
the initial recognition of the hybrid instrument (e.g., because the entity no longer
has sufficient authorized and unissued shares to share settle the feature; see Section 5.3.3), it no longer
meets the scope exception in ASC 815-10-15-74(a). Accordingly, the entity would need
to evaluate whether the feature should be separated as an embedded derivative under
ASC 815-15.
If separation is required after the initial recognition of the hybrid
instrument, the embedded derivative is bifurcated and recognized at fair value at
the time it ceases to meet the conditions for classification in equity. If no amount
was previously allocated to equity, a portion of the current carrying amount of the
hybrid instrument equal to the current fair value of the feature is allocated to the
embedded derivative (in accordance with ASC 815-15-30-2).
An embedded feature that was bifurcated from its host contract subsequently and
meets the conditions for equity classification in ASC 815-40 (e.g., because the
entity now has sufficient authorized and unissued shares to share settle the
feature)no longer meets the bifurcation criteria in ASC 815-15. Therefore, the
embedded feature should no longer be classified as an asset or a liability. However,
any previously recognized gains and losses should not be reversed (ASC
815-40-35-10). Instead, the carrying amount of the embedded derivative (i.e., the
fair value of the feature as of the date of the reclassification) should be
reclassified to shareholders’ equity. Any remaining debt discount (that arose from
the original bifurcation) should continue to be amortized (ASC 815-15-35-4). The
entity also should provide the disclosures required by ASC 815-15-50-3, as
applicable:
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 [ASC 815-15] no longer meets the separation
criteria under [ASC 815-15]:
-
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.
Example 6-5
Embedded Features
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’s common stock. The
fair value of one share of ABC’s common stock is $8.50 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 C). After ABC considers
its potential share requirements for other existing
commitments, it 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 following entry to bifurcate the embedded derivative (assume that the fair value of the conversion option on that date is $50):
Journal Entry: January 1, 20X5
As of each quarterly reporting date during 20X5, ABC determines that continued
bifurcation of the conversion option is required. For each
quarterly reporting period, the derivative is marked to fair
value, with the changes in fair value recognized in earnings
(the conversion option has a fair value of $200 on December
31, 20X5). Company ABC also recognizes its contractual
interest expense on the note, and it amortizes to interest
expense the debt discount created by the bifurcation of the
embedded conversion option. 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 $954 and $200, respectively.
Embedded Features
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.
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 value 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 is required to provide the disclosures described in ASC 815-15-50-3.