8.2 Identification of Embedded Features

8.2.1 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.

A contract that does not in its entirety meet the definition of a derivative (e.g., outstanding debt) may contain one or more embedded features that would have met the definition of a derivative (see Section 8.3.4) if they had been transacted on a stand-alone basis. ASC 815 describes a contract that contains an embedded derivative as a “hybrid instrument.” For example, debt with an equity conversion feature is a hybrid instrument. The contract in which such a feature is embedded is the host contract.

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 contractually 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 (see Section 3.3).

8.2.2 Payoff-Profile Approach to Identifying Embedded Derivatives

8.2.2.1 Background

To identify embedded derivatives, an entity should not rely solely on how terms are described in the contractual provisions of a debt 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 (see Section 3.2). 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 (see also Section 8.4.7.2.5). Further, the contractual conversion terms of a debt 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. Note, however, that 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 (e.g., a requirement to pay the present value of the remaining scheduled interest payments if a 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.

8.2.2.2 Features With Different Forms of Settlement

Different terms within a debt 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 instrument might contain provisions related to the redemption and conversion of the instrument in separate sections of the debt indenture. 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 debtor’s equity shares. In this example, the requirement to potentially redeem the debt 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 debt for cash at a fixed monetary amount would be evaluated as a redemption feature. See also Example 8-2.

8.2.2.3 Equity Conversion Features

Under the payoff-profile approach, an equity conversion feature (see Section 8.4.7.2.2) 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. A debt instrument may also contain (1) a provision that allows the holder to convert the instrument into a fixed number of equity shares (i.e., a conversion feature that requires settlement in shares) and (2) a provision that allows the holder to receive cash in an amount equal to 115 percent of the value of the fixed number of shares underlying the conversion feature (a cash-settled feature). In this circumstance, both provisions would be evaluated as a single embedded derivative. This is because the cash-settled feature, if exercised, results in the settlement of the monetary value underlying the conversion feature.

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 8-2.

8.2.2.4 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.

Connecting the Dots

A call option should be evaluated as a put option if the holder of the instrument controls the issuer’s board of directors or voting rights unless there are consent or other approval rights held by independent directors not appointed by the holder of the instrument.

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 8-2 for an illustration of the identification of the units of account for embedded redemption features.

8.2.2.5 Features With Interdependent Payoffs

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 8.4.11). 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 8-14 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 8.4.4 for further discussion of the evaluation of embedded call options.

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.

8.2.3 Illustrations of the Identification of Embedded Features

Example 8-1

Loan With Interest That Varies on the Basis of the Issuer’s Stock Market Capitalization

Entity 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., prime rate) plus an applicable margin. The applicable margin varies on the basis of the issuer’s stock market capitalization, as follows:

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 8.4.1). 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 8.4.1), the debtor’s creditworthiness (see Section 8.4.2), or inflation (see Section 8.4.3). 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 (see Section 8.4.7).

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.

Example 8-2

Convertible Promissory Note With Various Embedded Features

During the fiscal year ended December 31, 20X3, Entity B 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 B, 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 B 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 B’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 B’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 B’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 B’s preferred stock at a price per share equal to the quotient of $25 million and the amount of B’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 B’s common stock at a price per share equal to the quotient of $25 million and the amount of B’s fully diluted equity capital.
Revenue-based payment feature — Entity B 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 8.4.2.3).

Entity B 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 8.3.2). 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 settleable for the same monetary amount and no feature is a call option, B analyzes them as one combined embedded put feature under the guidance on redemption features (see Section 8.4.4):
- 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 B therefore analyzes it as a redemption feature under the monetary payoff profile approach (see Section 8.4.7.2.5).
- 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 B’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 B therefore analyzes it as a redemption feature under the monetary payoff profile approach (see also Section 8.4.7.2.5).
- 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 B 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 B.
Equity conversion feature — The following features have an equity-based return through conversion of the notes into B’s equity shares at a conversion price equal to the quotient of $25 million and the amount of B’s fully diluted equity capital. Because each feature has a payoff that is based on an equity return, B analyzes them as one combined embedded feature under the guidance on equity features (see Section 8.4.7):
- 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 B’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 B’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 B’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 B’s preferred stock at a price equal to the quotient of $25 million and the amount of B’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 B’s common stock at a price per share equal to the quotient of $25 million and the amount of B’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 8.4.2 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 8.4.10 for a discussion of the evaluation of such features).

Example 8-3

Note Convertible Into Shares and a Note

Entity C issues a note that contains the following conversion terms:

Upon any conversion other than the two types of conversions described below, the holder will receive, for each $1,000 principal amount of notes converted, (1) a $1,000 principal amount of a newly issued nonconvertible note with the same terms as the original note other than with respect to the conversion feature and (2) 50 shares of common stock.
If the note is converted in conjunction with a make-whole fundamental change event (i.e., a change of control of C, or C’s notice to exercise its right to redeem the note), the holder will receive, for each $1,000 principal amount of notes converted, 50 shares of common stock plus a specified number of additional shares of common stock that compensates the holder for lost time value upon early settlement of the note. (The number of additional shares of common stock depends on the date of early conversion and the issuer’s stock price on that date.)
If the note is converted at maturity, the holder will receive, for each $1,000 principal amount of notes converted, 50 shares of common stock.

Under the payoff-profile approach, there is only a single conversion feature. Since the holder can exercise its right of conversion and retain the note by receiving a note that is identical in all respects other than the conversion right, the note consists of the following two units of account:

A nonconvertible note.
A detachable warrant to purchase common stock.

This accounting is consistent with the guidance in ASC 470-50-25-2 and 25-3, which states:

25-2 Proceeds from the sale of a debt instrument with stock purchase warrants (detachable call options) shall be allocated to the two elements based on the relative fair values of the debt instrument without the warrants and of the warrants themselves at time of issuance. The portion of the proceeds so allocated to the warrants shall be accounted for as paid-in capital. The remainder of the proceeds shall be allocated to the debt instrument portion of the transaction. This usually results in a discount (or, occasionally, a reduced premium), which shall be accounted for under Topic 835.

25-3 The same accounting treatment applies to issues of debt instruments (issued with detachable warrants) that may be surrendered in settlement of the exercise price of the warrant. However, if stock purchase warrants are not detachable from the debt instrument and the debt instrument must be surrendered to exercise the warrant, the two instruments taken together are substantially equivalent to a convertible debt instrument and the accounting specified in paragraph 470-20-25-12 shall apply.

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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.