8.3 Bifurcation Criteria
8.3.1 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) when 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 8.3.2). For example, changes in the fair value of an equity interest — such as an equity conversion feature — are not clearly and closely related to changes in the interest rates on a debt host contract (see Section 8.4.7.3).
-
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 immediately through earnings (e.g., under the fair value option in ASC 815-15 or ASC 825-10; see Section 8.3.3).
- 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 8.3.4) and (2) the scope exceptions from derivative accounting in ASC 815-10 and ASC 815-15 (see Section 8.3.5).
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 have the net settlement characteristic included in such definition), 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 since 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.
8.3.2 Condition 1 — Not Clearly and Closely Related
8.3.2.1 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 manner in which an entity determines the nature of the
host contract depends on whether the hybrid contract is in the legal form of
debt (see the next section) or an outstanding share (see Section 4.3.2.3 of Deloitte’s Roadmap
Derivatives).
8.3.2.2 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. The terms of a debt host contract are identified 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 8.3.2.4). 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.
8.3.2.3 Hybrid Contracts in the Legal Form of an Outstanding Share
See Section 4.3.2.3
of Deloitte’s Roadmap Derivatives for guidance on determining the nature of
the host contract when the legal form of the hybrid instrument is an
outstanding share.
8.3.2.4 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 8.3.2.2). 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 of
Deloitte’s Roadmap Derivatives
for guidance on making this determination.
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.” 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.
8.3.2.5 Determining Whether an Embedded Feature Is Clearly and Closely Related to Its Host Contract
ASC 815 contains extensive application guidance on the evaluation of whether
particular types of embedded features should be considered clearly and
closely related to their host contracts (see Section 8.4). 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 8.4.1).
The table below provides examples of embedded features that would or would
not be considered clearly and closely related to a debt host contract. Note,
however, that the assessment could differ depending on the facts and
circumstances and other specific requirements of ASC 815.
|
Clearly and Closely Related
|
Not Clearly and Closely Related
|
|---|---|
|
|
Because the scope of this Roadmap is limited to debt instruments, it does not
address the evaluation of embedded features in equity host contracts.
8.3.3 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 issuer has applied the fair value option in ASC
815-15 or ASC 825-10 to a hybrid debt instrument (see Sections 4.4 and 8.5.6), 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 (see Section 6.3.2).
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), the issuer
cannot elect the fair value option for it.
If a liability is measured at (1) intrinsic value under the
indexed-debt guidance in ASC 470-10 (see Section 7.4.5) or (2) settlement value in
accordance with ASC 480-10-35-3 (see Section 4.3.1.2 and Section 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.
8.3.4 Condition 3 — Derivative Instrument
8.3.4.1 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: . . .
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.)
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.
-
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. This condition is
satisfied if the feature both (1) would have met the definition of a
derivative instrument in ASC 815-10 if it had been a freestanding contract
and (2) does not meet any of the scope exceptions in ASC 815-10 and ASC
815-15. An entity is not permitted to bifurcate as a derivative an embedded
feature that (1) does not meet the definition of a derivative instrument on
a freestanding basis or (2) qualifies for a derivative scope exception.
To evaluate whether an embedded feature would have met the definition of a
derivative instrument on a freestanding basis, an entity considers whether
the feature possesses all three characteristics of a derivative instrument
described in ASC 815-10-15-83:
-
Underlying and either a notional amount or payment provision (see Section 8.3.4.2).
-
Initial net investment (see Section 8.3.4.3).
-
Net settlement (see Section 8.3.4.4).
Under ASC 815, a feature that does not possess all of these characteristics
is not considered a derivative (i.e., it should not be separated as a
derivative). Further, a feature that meets the definition of a derivative
instrument should not be bifurcated if it meets one or more scope exception
in either ASC 815-10-15 or ASC 815-15-15 (see Section
8.3.5).
8.3.4.2 Underlying, Notional Amount, and Payment Provision Terms
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. . . .
-
The first characteristic of a derivative in ASC 815-10-15-83
is that it has both “[o]ne or more underlyings” (see the next section) and
either “[o]ne or more notional amounts or payment provisions or both” (see
Section
8.3.4.2.2).
8.3.4.2.1 Underlying
ASC Master 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.
15-91 Example 3 (see
paragraph 815-10-55-77) illustrates the
determination of an underlying if a commodity
contract includes a fixed element and a variable
element.
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.
Examples of the underlyings of features embedded in a debt host contract
include the following:
-
Interest rates or interest rate indexes — The interest payments on some debt instruments fluctuate on the basis of changes in market interest rates, such as SOFR. Such fluctuations might be subject to a maximum rate (a cap), a minimum rate (a floor), or a range (collar). In addition, the debtor might have a right to elect which variable interest rate index will apply (a choose-your-rate option). Many debt instruments contain put or call options that could change the rate of return realized by the creditor if they are triggered. See Section 8.4.1 for further discussion.
-
Credit ratings or other measures of credit risk — Some debt instruments have interest payments that vary on the basis of a measure of the debtor’s credit risk, such as an external credit rating. Alternatively, a debt instrument might require additional interest to be paid upon an event of default involving the debtor. See Section 8.4.2 for further discussion.
-
Inflation rates — Inflation-indexed debt securities pay interest that varies on the basis of changes in an inflation index, such as a CPI. See Section 8.4.3 for further discussion.
-
The occurrence or nonoccurrence of specified events — Debt instruments often contain features that accelerate repayment or permit prepayment of amounts due or require specified payments to be made upon the occurrence or nonoccurrence of specified events. For example, debt instruments often contain put or call options that are contingent on the occurrence or nonoccurrence of a change of control, an IPO, a qualified debt or equity financing, the debtor’s stock price, or the debt’s traded price. Further, many debt instruments require additional interest to be paid upon the occurrence or nonoccurrence of specified events, such as the inability to freely trade the instrument or the achievement of business milestones. See Sections 8.4.4 (puts, calls, and other redemption features) and 8.4.11 (other contingent payments) for further discussion.
-
Stock prices or stock price indexes — When debt is convertible into a fixed number of the debtor’s equity shares (e.g., common or preferred stock), the share price is an underlying of the conversion feature. When the monetary value of the payoff fluctuates on the basis of changes in a stock price, the stock price is considered an underlying even if the contractual terms do not explicitly refer to the stock price. For example, the terms of a conversion feature that requires gross physical settlement in a fixed number of shares upon conversion might not refer to the stock price. Nevertheless, the stock price is an underlying because the monetary value of the conversion feature fluctuates on the basis of changes in the price of the shares that would be delivered upon conversion. See Section 8.4.7 for further discussion.
-
Currency exchange rates or currency exchange rate indexes — A debt instrument might contain terms that permit payments to be made in more than one currency at a fixed or specified exchange rate. Other debt instruments have principal and interest payments that are denominated in different currencies. See Section 8.4.8 for further discussion.
-
Commodity prices or commodity price indexes — Sometimes, the payments on a debt instrument fluctuate on the basis of changes in the price of a commodity, such as gold, crude oil, or natural gas. See Section 8.4.9 for further discussion.
-
Sales volume, revenue, or other performance metrics — Some debt instruments require payments that vary on the basis of changes in measures of sales volume, revenue, or earnings. See Section 8.4.10 for further discussion.
In the determination of the contractual cash flows or other exchanges
required by a derivative and its 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).
8.3.4.2.2 Notional Amount or Payment Provision
ASC Master 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.
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
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.
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.
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 debt instrument).
A payment provision is a fixed or determinable payment that is triggered
by specified changes in the underlying. Examples include the payment of
a fixed amount upon the occurrence or nonoccurrence of an event (e.g.,
change of control or an event of default).
8.3.4.3 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. . . .
15-96 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.
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
contract’s initial net investment with 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 usually must be 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 present.
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 present for embedded features in debt host contracts.
Example 8-4
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 present, 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 present.
8.3.4.4 Net Settlement
8.3.4.4.1 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:
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.
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.
The third characteristic of a derivative in ASC
815-10-15-83 is net settlement. ASC 815-10 indicates that a contract
possesses the net settlement characteristic specified in the definition
of a derivative if it permits net settlement in any of the following
ways: (1) under the contractual terms (see Section 8.3.4.4.2), (2) through a
market mechanism (see Section 8.3.4.4.3), or (3) by delivery of a derivative
instrument or an asset that is readily convertible to cash (see
Section
8.3.4.4.4).
The table below lists examples of features that may or
may not contain the net settlement characteristic if they are embedded
in a debt host contract.
|
Net Settlement Characteristic
Present
|
Net Settlement Characteristic
Not Present
|
|---|---|
|
|
8.3.4.4.2 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.
In a contractual net settlement, 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. 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. An embedded
feature in a debt host contract that is contractually settled net would
meet this condition (e.g., a conversion feature that permits net share
or net cash settlement of the conversion spread while the principal
amount of the debt is settled in cash). If the contractual terms require
or permit either party to elect net settlement, the net settlement
characteristic is present even if the item that may be delivered upon
settlement is not readily convertible to cash (e.g., a net share
settlement involving private company shares; see Section
8.4.7).
In accordance with ASC 815-10-15-107, the exercise of an embedded put or
call option in a debt host contract is considered a contractual net
settlement of that embedded option “because neither party is required to
deliver an asset that is associated with the underlying” (see
Section 8.4.4.4).
8.3.4.4.3 Net Settlement Through a Market Mechanism
ASC 815-10
Net Settlement Through a Market
Mechanism . . .
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.
The net settlement characteristic is present 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 is typically not applicable 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 (see Section 3.3.2).
8.3.4.4.4 Net Settlement by Delivery of a Derivative Instrument or an Asset Readily Convertible to Cash
ASC Master 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.
ASC 815-10
Net Settlement by Delivery of Derivative
Instrument or Asset Readily Convertible to
Cash
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.
15-121 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.
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.
A contract possesses the net settlement characteristic
if it 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 readily convertible to cash or are derivatives, the
contract has the net settlement characteristic. ASC 815-10-20 specifies
that an item is “readily convertible to cash” 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.” For example, an equity
conversion feature embedded in a debt host would be considered readily
convertible to cash if the shares that would be delivered upon
conversion can be rapidly absorbed in the market without significantly
affecting the stock price (see Section 8.4.7.5). 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 readily convertible to cash
(see ASC 815-10-15-126). The evaluation of whether an embedded feature
is readily convertible to cash is performed on the basis of the smallest
increment in which it can be settled under its contractual terms (see
Section
8.4.7.5).
8.3.4.4.5 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.
An entity is required to evaluate whether a market
mechanism exists (see Section 8.3.4.4.3) and whether the items to be delivered
are readily convertible to cash (see Section 8.3.4.4.4) both at
inception and on an ongoing basis throughout a contract’s life. For
example, an embedded conversion feature might become readily convertible
to cash after the issuance of a debt contract if the shares to be
delivered upon exercise of the conversion feature are not initially
readily convertible to cash but the entity subsequently undertakes an
IPO or the market trading volume increases such that those shares become
capable of being rapidly absorbed in the market without significantly
affecting the stock price (see Section 8.4.7.5.6). Conversely, an
embedded conversion feature might cease to be readily convertible to
cash if the shares are no longer listed on a stock exchange. However, an
entity should not reassess whether the costs needed to immediately
convert the asset to cash would exceed 10 percent of the spot price (see
Section 8.3.4.4.4).
8.3.5 Scope Exceptions
ASC 815-10
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.
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.
Some of those scope exceptions might be more relevant to a debtor that evaluates
features embedded in debt host contracts, including those related to the following:
-
Certain insurance contracts (see ASC 815-10-15-52 through 15-57). A contract or feature is not subject to ASC 815 “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.” A disaster bond might qualify for this scope exception (see Section 8.4.12.4).
-
Certain financial guarantee contracts (see ASC 815-10-15-58). An embedded credit derivative in a credit-linked note could potentially qualify for this scope exception (see Section 8.4.2.5).
-
Certain contracts that are not traded on an exchange if the underlying on which the settlement is based on one of the following (ASC 815-10-15-59):
-
A climatic or geological or other physical variable (see Section 8.4.12.3).
-
The price or value of a nonfinancial asset of one of the parties to the contract if the asset is not readily convertible to cash. For example, this scope exception may be relevant for a participation feature in a participating mortgage (see Sections 7.3 and 8.4.9.5).
-
The fair value of a nonfinancial liability of one of the parties to the contract and the asset delivered is not readily convertible to cash.
-
Specified volumes of sales or service revenue of one of the parties to the contract. For example, an entity would evaluate interest payments indexed to sales revenue to determine whether they meet this scope exception (see Sections 7.2 and 8.4.10.5).
-
After the adoption of ASU 2025-07, operations or activities specific to one of the parties to the contract (see Section 8.4.11.5).
-
-
Loan commitments (see ASC 815-10-15-69 through 15-71 and Section 8.4.6.5). Note that an entity may evaluate a term extension option (see Section 8.4.5.5) or PIK feature embedded in a debt instrument to determine whether it meets this scope exception.
-
Contracts that are both indexed to the entity’s own stock and classified in stockholders’ equity (see ASC 815-10-15-74(a)). An entity would evaluate an embedded conversion feature to determine whether it meets this scope exception (see Section 8.4.7.6).
-
Contracts within the scope of ASC 718 (see ASC 815-10-15-74(b)). A convertible debt instrument issued in exchange for goods or services may meet this scope exception (see Section 8.4.7.7).
-
Registration payment arrangements (ASC 815-10-15-82; see Sections 3.3.3.2 and 8.4.12.2).
-
Monetary items that have principal or interest payments denominated in a foreign currency and for which foreign currency transaction gains and losses are recognized under ASC 830 (see Section 8.4.8.5). For example, this exception applies to certain dual currency bonds.