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 satisfy the net settlement characteristic in the definition of a derivative), it is unnecessary to evaluate whether it (1) is subject to any scope exception related to derivative accounting or (2) is clearly and closely related to its host contract 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 8.3.2.3).

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

8.3.2.3.1 General

ASC 815-15

25-16 If the host contract encompasses a residual interest in an entity, then its economic characteristics and risks shall be considered that of an equity instrument and an embedded derivative would need to possess principally equity characteristics (related to the same entity) to be considered clearly and closely related to the host contract.

25-17 Because the changes in fair value of an equity interest and interest rates on a debt instrument are not clearly and closely related, the terms of convertible preferred stock shall be analyzed to determine whether the preferred stock (and thus the potential host contract) is more akin to an equity instrument or a debt instrument.

25-17A For a hybrid financial instrument issued in the form of a share, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, weighing each term and feature on the basis of the relevant facts and circumstances. That is, in determining the nature of the host contract, an entity shall consider the economic characteristics and risks of the entire hybrid financial instrument including the embedded derivative feature that is being evaluated for potential bifurcation. In evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature does not necessarily determine the economic characteristics and risks of the host contract. Although an individual term or feature may weigh more heavily in the evaluation on the basis of the facts and circumstances, an entity should use judgment based on an evaluation of all of the relevant terms and features. For example, an entity shall not presume that the presence of a fixed-price, noncontingent redemption option held by the investor in a convertible preferred stock contract, in and of itself, determines whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument. Rather, the nature of the host contract depends on the economic characteristics and risks of the entire hybrid financial instrument.

25-17B The guidance in paragraph 815-15-25-17A relates to determining whether a host contract within a hybrid financial instrument issued in the form of a share is considered to be more akin to a debt instrument or more akin to an equity instrument for the purposes of evaluating one or more embedded derivative features for bifurcation under paragraph 815-15-25-1(a). It is not intended to address when an embedded derivative feature should be bifurcated from the host contract or the accounting when such bifurcation is required. In addition, the guidance in paragraph 815-15-25-17A is not intended to prescribe the method to be used in determining the nature of the host contract in a hybrid financial instrument that is not issued in the form of a share.

If the host contract is in the legal form of a share (e.g., preferred stock), the evaluation of whether the contract should be considered a debt host or an equity host is not based solely on its legal form or whether it qualifies for presentation as equity (including temporary equity) under GAAP. Instead, an entity is required to use a “whole-instrument approach” under which it determines the nature of the host contract by considering all of its stated or implied substantive terms and features. Accordingly, an entity must further analyze the economic characteristics and risks of the hybrid contract to determine whether the contract should be considered a debt host or an equity host. For example, an outstanding share that is classified as a liability under ASC 480 or as temporary equity under ASC 480-10-S99-3A could potentially qualify as a debt host contract depending on its terms and conditions.

An entity must identify the nature of the host contract as of the hybrid instrument’s initial recognition date (i.e., upon its issuance or acquisition). The entity is required to reassess that determination upon a modification or exchange of the hybrid instrument that is accounted for as an extinguishment (see Section 10.4.2). The determination of whether a reassessment is required for a modification or exchange that is not accounted for as an extinguishment depends on the relevant facts and circumstances.

Because this Roadmap addresses the issuer’s accounting for debt, the accounting for outstanding shares is beyond its scope except for certain types of liability-classified shares (see Section 2.3.2.3). Liability-classified outstanding shares will generally contain debt host contracts. However, it is possible for a such a share to contain an equity host contract. Furthermore, some equity-classified hybrid instruments will contain debt hosts (in which case the evaluation of embedded derivatives is the same as that for a hybrid instrument that is in the legal form of debt). The sections below therefore discuss the guidance on determining the nature of the host contract for a hybrid instrument in the form of a share.

8.3.2.3.2 Framework for Determining Whether an Outstanding Share Is a Debt Host or an Equity Host

ASC 815-15

25-17C When applying the guidance in paragraph 815-15-25-17A, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, determining whether those terms and features are debt-like versus equity-like, and weighing those terms and features on the basis of the relevant facts and circumstances. That is, an entity shall consider not only whether the relevant terms and features are debt-like versus equity-like, but also the substance of those terms and features (that is, the relative strength of the debt-like or equity-like terms and features given the facts and circumstances). In assessing the substance of the relevant terms and features, each of the following may form part of the overall analysis and may inform an entity’s overall consideration of the relative importance (and, therefore, weight) of each term and feature among other terms and features:

The characteristics of the relevant terms and features themselves (for example, contingent versus noncontingent, in-the-money versus out-of-the-money)
The circumstances under which the hybrid financial instrument was issued or acquired (for example, issuer-specific characteristics, such as whether the issuer is thinly capitalized or profitable and well-capitalized)
The potential outcomes of the hybrid financial instrument (for example, the instrument may be settled by the issuer issuing a fixed number of shares, the instrument may be settled by the issuer transferring a specified amount of cash, or the instrument may remain legal-form equity), as well as the likelihood of those potential outcomes. The assessment of the potential outcomes may be qualitative in nature.

25-17D The following are examples (and not an exhaustive list) of common terms and features included within a hybrid financial instrument issued in the form of a share and the types of information and indicators that an entity (an issuer or an investor) may consider when assessing the substance of those terms and features in the context of determining the nature of the host contract, as discussed in paragraph 815-15-25-17C:

Redemption rights. The ability for an issuer or investor to redeem a hybrid financial instrument issued in the form of a share at a fixed or determinable price generally is viewed as a debt-like characteristic. However, not all redemption rights are of equal importance. For example, a noncontingent redemption option may be given more weight in the analysis than a contingent redemption option. The relative importance (and, therefore, weight) of redemption rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. Whether the redemption right is held by the issuer or investors
2. Whether the redemption is mandatory
3. Whether the redemption right is noncontingent or contingent
4. Whether (and the degree to which) the redemption right is in-the-money or out-of-the-money
5. Whether there are any laws that would restrict the issuer or investors from exercising the redemption right (for example, if redemption would make the issuer insolvent)
6. Issuer-specific considerations (for example, whether the hybrid financial instrument is effectively the residual interest in the issuer [due to the issuer being thinly capitalized or the common equity of the issuer having already incurred losses] or whether the instrument was issued by a well-capitalized, profitable entity)
7. If the hybrid financial instrument also contains a conversion right, the extent to which the redemption price (formula) is more or less favorable than the conversion price (formula), that is, a consideration of the economics of the redemption price (formula) and the conversion price (formula), not simply the form of the settlement upon redemption or conversion.
Conversion rights. The ability for an investor to convert, for example, a preferred share into a fixed number of common shares generally is viewed as an equity-like characteristic. However, not all conversion rights are of equal importance. For example, a conversion option that is noncontingent or deeply in-the-money may be given more weight in the analysis than a conversion option that is contingent on a remote event or deeply out-of-the-money. The relative importance (and, therefore, weight) of conversion rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. Whether the conversion right is held by the issuer or investors
2. Whether the conversion is mandatory
3. Whether the conversion right is noncontingent or contingent
4. Whether (and the degree to which) the conversion right is in-the-money or out-of-the-money
5. If the hybrid financial instrument also contains a redemption right held by the investors, whether conversion is more likely to occur before redemption (for example, because of an expected initial public offering or change-in-control event before the redemption right becoming exercisable).
Voting rights. The ability for a class of stock to exercise voting rights generally is viewed as an equity-like characteristic. However, not all voting rights are of equal importance. For example, voting rights that allow a class of stock to vote on all significant matters may be given more weight in the analysis than voting rights that are only protective in nature. The relative importance (and, therefore, weight) of voting rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. On which matters the voting rights allow the investor’s class of stock to vote (relative to common stock shareholders)
2. How much influence the investor’s class of stock can exercise as a result of the voting rights.
Dividend rights. The nature of dividends can be viewed as a debt-like or equity-like characteristic. For example, mandatory fixed dividends generally are viewed as a debt-like characteristic, while discretionary dividends based on earnings generally are viewed as an equity-like characteristic. The relative importance (and, therefore, weight) of dividend terms among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. Whether the dividends are mandatory or discretionary
2. The basis on which dividends are determined and whether the dividends are stated or participating
3. Whether the dividends are cumulative or noncumulative.
Protective covenants. Protective covenants generally are viewed as a debt-like characteristic. However, not all protective covenants are of equal importance. Covenants that provide substantive protective rights may be given more weight than covenants that provide only limited protective rights. The relative importance (and, therefore, weight) of protective covenants among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. Whether there are any collateral requirements akin to collateralized debt
2. If the hybrid financial instrument contains a redemption option held by the investor, whether the issuer’s performance upon redemption is guaranteed by the parent of the issuer
3. Whether the instrument provides the investor with certain rights akin to creditor rights (for example, the right to force bankruptcy or a preference in liquidation).

To determine the nature of the host contract under the whole-instrument approach, an entity performs the following steps:

Identify all of the hybrid financial instrument’s stated and implied substantive terms and features (see Section 8.3.2.3.3).
Determine whether each of the identified terms and features is more debt-like or equity-like (see Section 8.3.2.3.4).
Consider the relative weight of the identified terms and features “on the basis of the relevant facts and circumstances” (see Section 8.3.2.3.5).
Reach a conclusion about the nature of the host contract (see Section 8.3.2.3.6).

8.3.2.3.3 Step 1 — Identify the Hybrid Instrument’s Substantive Terms and Features

The first step in applying the whole-instrument approach is to identify all of the substantive terms and features of the hybrid financial instrument, whether stated or implied. ASC 815-15-25-17D lists common terms and features in hybrid instruments that are in the form of shares.

8.3.2.3.4 Step 2 — Determine Whether the Identified Terms and Features Are More Debt-Like or Equity-Like

The next step in applying the whole-instrument approach is to determine whether the identified substantive terms and features of the hybrid instrument are more debt- or equity-like. To make this determination, an entity should analyze the terms’ or features’ economic characteristics and risks.

ASC 815-15-25-16 explains that a host contract is considered equity-like if it “encompasses a residual interest in an entity.” By contrast, a term or feature that is not consistent with a residual interest in the issuing entity would most likely be considered debt-like. ASC 815-15-25-17D provides examples of common terms and features, discusses whether such terms and features are generally debt- or equity-like, and lists factors that an entity might consider in determining the relative weight to assign to such terms and features.

The following chart illustrates which characteristics are generally more debt-like or equity-like:

8.3.2.3.5 Step 3 — Weigh the Identified Terms and Features

The third step is to weigh each of the hybrid financial instrument’s substantive terms and features — qualitatively, quantitatively, or both — “on the basis of the relevant facts and circumstances,” as described in ASC 815-15-25-17C. The entity determines the “relative strength” or weight of each of the hybrid financial instrument’s substantive terms and features by considering the following:

The characteristics of the relevant terms and features themselves — For example, for a redemption option, the entity should consider whether the option is (1) mandatory or optional and (2) contingent or noncontingent. A mandatory redemption right would be given more weight than an optional redemption right, and a noncontingent redemption right would be given more weight than a contingent redemption right. ASC 815-15-25-17D provides a list of characteristics that a reporting entity should consider in its analysis. Although not an all-inclusive list, these characteristics are discussed further in the table below.
The circumstances under which the hybrid financial instrument was issued or acquired — This condition is generally meant to help an entity assess whether the hybrid financial instrument is, in substance, a residual interest in the issuing entity. For example, a hybrid financial instrument issued by a thinly capitalized entity (or one with an accumulated deficit) might be considered more equity-like than a hybrid financial instrument issued by a well-capitalized profitable entity. This is because in a thinly capitalized entity, the hybrid financial instrument may, in substance, represent a residual interest in that issuing entity even if other classes of equity are more subordinated.
The potential outcomes of the hybrid financial instrument as well as the likelihood of those potential outcomes — This condition is meant to help an entity assess the hybrid financial instrument’s likely economic return. For example, a hybrid financial instrument that is expected to be settled in a fixed number of common shares (thus providing a more equity-like return) might be viewed as more equity-like than a hybrid financial instrument that is expected to be settled in a specified amount of cash or a variable number of shares that is equal to a fixed dollar amount (thus providing a more debt-like return).

The table below provides examples of indicators that a reporting entity should consider in determining whether to assign more or less weight to the general view related to whether a term or feature is debt-like or equity-like in the entity’s analysis of the nature of the host contract for a hybrid instrument issued in the form of a share. This table does not apply to hybrid instruments issued in the form of debt.

General View	Indicators That the General View Should Be Given More Weight	Indicators That the General View Should Be Given Less Weight
Redemption rights are debt-like	The redemption rights are held by an investor. The instrument is mandatorily redeemable. The redemption rights are noncontingent. The term or feature is in-the-money (the degree to which the term or feature is in-the-money should also be considered). For instruments with both redemption and conversion features, the redemption price or formula is more favorable than the conversion price or formula. The issuer is well capitalized and profitable. There are no laws restricting the exercise of the redemption rights. The redemption rights can be exercised in circumstances besides liquidations. The redemption feature can be settled by the issuer’s transfer of a specified amount of cash or a variable number of shares that is equal to a fixed dollar amount. (A redemption amount that varies with the passage of time, such as how interest on a debt instrument accrues, would be a debt-like feature.)	The redemption rights are held by the issuer. The instrument is not mandatorily redeemable. The redemption rights are contingent. The term or feature is out-of-the-money (the degree to which the term or feature is out-of-the-money should also be considered). For instruments with both redemption and conversion features, the redemption price or formula is less favorable than the conversion price or formula. The issuer is thinly capitalized and incurring losses. Laws might restrict the exercise of the redemption rights. The redemption rights can only be exercised in the event of a liquidation. The settlement value of the redemption feature is not fixed. (A redemption amount that varies with the passage of time, such as how interest on a debt instrument accrues, would be a debt-like feature.)
Conversion rights are an equity-like term or feature	The conversion rights are held by an investor. The instrument is mandatorily convertible. The conversion rights are noncontingent. The conversion term or feature is in-the-money (the degree to which the term or feature is in-the-money should also be considered). For instruments with both redemption and conversion features, conversion is more likely to occur before redemption. The instrument can be converted into or otherwise settled in a fixed number of common shares.	The conversion rights are held by the issuer. The instrument is not mandatorily convertible. The conversion rights are contingent. The conversion term or feature is out-of-the-money (the degree to which the term or feature is out-of-the-money should also be considered). For instruments with both redemption and conversion features, conversion is less likely to occur before redemption. The instrument is convertible into a variable number of shares equal to a fixed dollar amount.
Voting rights are an equity-like term or feature	The voting rights allow holders of a class of stock to vote on all significant matters (i.e., exercise significant influence). The voting rights allow the investor class to vote on the same matters as common stockholders. The investor is granted the right to appoint board members.	The voting rights are only protective (i.e., influence is not significant). The voting rights of the investor class are more restrictive than those of the common stockholders. The investor does not have the right to appoint board members.
Protective covenants are a debt-like term or feature	For redemption options, redemption is guaranteed by the issuer’s parent. The investor has certain rights that are akin to creditor rights (e.g., the right to force bankruptcy or a liquidation preference). The investor has collateral requirements that are akin to those for collateralized debt.	For redemption options, redemption is not guaranteed by any entity other than the issuer. The investor has no rights that are akin to creditor rights. There are no collateral requirements.
Dividends are either a debt-like or an equity-like feature	Dividend rights that are mandatory, stated, or cumulative add weight to the view that a debt host is more debt-like. Dividend rights that are discretionary, participating, or noncumulative add weight to the view that a debt host is more equity-like.

8.3.2.3.6 Step 4 — Reach a Conclusion About the Nature of the Host Contract

The final step is to reach a conclusion regarding the nature of the host contract on the basis of the results of the analyses performed in the previous steps. As explained in ASC 815-15-25-17A, “[i]n evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature does not necessarily determine the economic characteristics and risks of the host contract. Although an individual term or feature may weigh more heavily in the evaluation on the basis of the facts and circumstances, an entity should use judgment based on an evaluation of all of the relevant terms and features.” To further emphasize this point, ASC 815-15-25-17A states by way of example that “an entity shall not presume that the presence of a fixed-price, noncontingent redemption option held by the investor in a convertible preferred stock contract, in and of itself, determines whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument.” If the nature of the host contract is still not clear, the entity should consider the expected outcome of the hybrid financial instrument in reaching a conclusion. Given the complexity of determining the nature of a host contract of a hybrid instrument with both conversion and redemption features, entities are encouraged to consult with their accounting advisers.

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 8.3.2.3).

The terms of a debt host contract are identified on the basis of the terms of the hybrid debt instrument. For example, a fixed-rate hybrid debt contract would have a fixed-rate debt host contract, and a variable-rate hybrid debt contract would have a variable-rate debt host contract. An entity is not permitted to impute terms in the host contract that are not clearly present in the hybrid instrument, such as artificial terms that “introduce leverage, asymmetry, or some other risk exposure not already present in the hybrid instrument.” 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
Fixed, noncontingent interest and principal payments (see Section 8.4.1.3) Payments indexed to an interest rate unless otherwise indicated under either the negative-yield test or the double-double test (ASC 815-15-25-26; see Section 8.4.1.3) A noncontingent call option that can accelerate the repayment of principal unless the negative-yield test in ASC 815-15-25-26(a) indicates otherwise (see Section 8.4.1.3.3) A noncontingent put option that can accelerate the repayment of principal unless otherwise indicated under the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4) Credit-sensitive interest payments linked to the creditworthiness of the debtor (see Section 8.4.2.3) Nonleveraged principal or interest payments indexed to the rate of inflation in the economic environment of the currency in which the debt instrument is denominated (see Section 8.4.3.3) A contingent call or put option that can accelerate the repayment of principal if the debt does not involve a substantial premium or discount (see Section 8.4.4.3) Options to extend the term if, upon exercise, the interest rate is reset to the approximate current market rate and the instrument was not issued at a discount (see Section 8.4.5.3)	Payments indexed to an interest rate that pass the negative-yield test (i.e., ASC 815-15-25-26(a); see Section 8.4.1.3.3) A noncontingent call option that passes the negative-yield test (ASC 815-15-25-26(a); see Section 8.4.1.3.3) Payments indexed to an interest rate that pass the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4) A noncontingent put option that passes the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4) Credit-sensitive payments linked to a credit exposure other than the creditworthiness of the debtor (see Section 8.4.2.3) Principal or interest payments indexed to the rate of inflation in the economic environment of a currency that is different from that in which the debt instrument is denominated (see Section 8.4.3.3) A contingent put or call option if the debt involves a substantial premium or discount (see Section 8.4.4.3) A put or call option that has a payoff indexed to an underlying other than interest rates or credit risk (see Section 8.4.4.3) Option to extend the term if the interest rate is not reset to the approximate current market rate (see Section 8.4.5.3) An equity conversion feature (see Section 8.4.7.3.1) Equity-indexed payments (see Section 8.4.7.3.2) Commodity-indexed payments (see Section 8.4.9.3) Payments contingent on the occurrence or nonoccurrence of specified events unrelated to an interest rate index or the credit risk of the issuer (see Section 8.4.11.3)

Clearly and Closely Related

Not Clearly and Closely Related

Fixed, noncontingent interest and principal payments (see Section 8.4.1.3)
Payments indexed to an interest rate unless otherwise indicated under either the negative-yield test or the double-double test (ASC 815-15-25-26; see Section 8.4.1.3)
A noncontingent call option that can accelerate the repayment of principal unless the negative-yield test in ASC 815-15-25-26(a) indicates otherwise (see Section 8.4.1.3.3)
A noncontingent put option that can accelerate the repayment of principal unless otherwise indicated under the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4)
Credit-sensitive interest payments linked to the creditworthiness of the debtor (see Section 8.4.2.3)
Nonleveraged principal or interest payments indexed to the rate of inflation in the economic environment of the currency in which the debt instrument is denominated (see Section 8.4.3.3)
A contingent call or put option that can accelerate the repayment of principal if the debt does not involve a substantial premium or discount (see Section 8.4.4.3)
Options to extend the term if, upon exercise, the interest rate is reset to the approximate current market rate and the instrument was not issued at a discount (see Section 8.4.5.3)

Payments indexed to an interest rate that pass the negative-yield test (i.e., ASC 815-15-25-26(a); see Section 8.4.1.3.3)
A noncontingent call option that passes the negative-yield test (ASC 815-15-25-26(a); see Section 8.4.1.3.3)
Payments indexed to an interest rate that pass the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4)
A noncontingent put option that passes the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4)
Credit-sensitive payments linked to a credit exposure other than the creditworthiness of the debtor (see Section 8.4.2.3)
Principal or interest payments indexed to the rate of inflation in the economic environment of a currency that is different from that in which the debt instrument is denominated (see Section 8.4.3.3)
A contingent put or call option if the debt involves a substantial premium or discount (see Section 8.4.4.3)
A put or call option that has a payoff indexed to an underlying other than interest rates or credit risk (see Section 8.4.4.3)
Option to extend the term if the interest rate is not reset to the approximate current market rate (see Section 8.4.5.3)
An equity conversion feature (see Section 8.4.7.3.1)
Equity-indexed payments (see Section 8.4.7.3.2)
Commodity-indexed payments (see Section 8.4.9.3)
Payments contingent on the occurrence or nonoccurrence of specified events unrelated to an interest rate index or the credit risk of the issuer (see Section 8.4.11.3)

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 Sections 4.3.1.2 and 5.3.1.1 of Deloitte’s Roadmap Distinguishing Liabilities From Equity), an entity should not consider the liability to be accounted for at fair value when assessing whether an embedded feature must be bifurcated. Although the intrinsic value or settlement value might approximate fair value, it does not take into account all of an instrument’s attributes that are included in a fair value estimate — for example, the time value of an option. Thus, an instrument that is remeasured at intrinsic value or settlement value may contain an embedded feature that must be bifurcated.

8.3.4 Condition 3 — Derivative Instrument

8.3.4.1 Background

ASC 815-15

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:
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.

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:
1. One or more underlyings
2. 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 LIBOR or 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 met.

The initial investment in a hybrid instrument is not considered the initial net investment for an embedded feature in that instrument (as noted in ASC 815-15-25-1). Instead, the initial net investment in the embedded feature is the amount an entity would have been required to invest in a freestanding contract with terms that are similar to those of the embedded feature, excluding the host contract of the hybrid instrument. That is, the initial investment needed to acquire or incur the host contract (e.g., the fair value of a debt host contract) does not form part of the initial investment of any embedded feature in the same hybrid instrument. Therefore, the initial net investment characteristic typically is met for embedded features in debt host contracts.

Example 8-3

Initial Net Investment in Conversion Option Embedded in a Debt Instrument

The initial net investment in a conversion option embedded in a debt instrument is the option’s fair value; it is not the fair value of the convertible debt or the fair value of the shares that would be delivered upon exercise of the conversion feature. When evaluating whether the initial net investment characteristic is met, an entity compares the fair value of the conversion option on the date of the debt’s issuance with the fair value of the underlying shares that are deliverable to the holders upon exercise of the conversion option. If the fair value of the conversion option is less, by more than a nominal amount, than the fair value of the instrument into which the option is convertible on the date of issuance, the initial net investment characteristic is met.

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 specifies that a contract meets the net settlement characteristic 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 meet the net settlement characteristic if they are embedded in a debt host contract.

Net Settlement Characteristic Met	Net Settlement Characteristic Not Met
Cash-settled put or call option (see Section 8.3.4.4.2) Cash-settled redemption feature (see Section 8.3.4.4.2) Conversion feature that involves delivery of shares that are readily convertible to cash (e.g., publicly traded stock; see Section 8.3.4.4.4) Net-share-settled conversion feature (irrespective of whether the stock is readily convertible to cash; see Section 8.3.4.4.2) Share-settled redemption feature (e.g., a conversion feature that involves the delivery of a variable number of shares worth a specified monetary amount at settlement irrespective of whether the stock is readily convertible to cash; see Section 8.3.4.4.2) Indexed principal or interest payments (see Section 8.3.4.4.2) Contingent payment feature (e.g., additional cash interest upon an event of default; see Section 8.3.4.4.2)	Conversion feature that requires gross physical settlement by delivery of a fixed number of shares that are not readily convertible to cash (e.g., private-company stock; see Section 8.3.4.4.4) Term extension feature that requires delivery of debt that is not readily convertible to cash (see Section 8.4.5.4) Embedded loan commitment (e.g., a PIK interest feature) that requires delivery of debt that is not readily convertible to cash (see Section 8.4.6.4)

Net Settlement Characteristic Met

Net Settlement Characteristic Not Met

Cash-settled put or call option (see Section 8.3.4.4.2)
Cash-settled redemption feature (see Section 8.3.4.4.2)
Conversion feature that involves delivery of shares that are readily convertible to cash (e.g., publicly traded stock; see Section 8.3.4.4.4)
Net-share-settled conversion feature (irrespective of whether the stock is readily convertible to cash; see Section 8.3.4.4.2)
Share-settled redemption feature (e.g., a conversion feature that involves the delivery of a variable number of shares worth a specified monetary amount at settlement irrespective of whether the stock is readily convertible to cash; see Section 8.3.4.4.2)
Indexed principal or interest payments (see Section 8.3.4.4.2)
Contingent payment feature (e.g., additional cash interest upon an event of default; see Section 8.3.4.4.2)

Conversion feature that requires gross physical settlement by delivery of a fixed number of shares that are not readily convertible to cash (e.g., private-company stock; see Section 8.3.4.4.4)
Term extension feature that requires delivery of debt that is not readily convertible to cash (see Section 8.4.5.4)
Embedded loan commitment (e.g., a PIK interest feature) that requires delivery of debt that is not readily convertible to cash (see Section 8.4.6.4)

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 met 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 met if an established market mechanism exists that facilitates net settlement outside of the contract, such as the ability to sell the derivative on an exchange. This condition 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.

(Based on paragraph 83(a) of FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises.)

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.

The net settlement characteristic is met if the contract is settled in a manner in which the recipient’s position is not substantially different from that in a contractual net settlement. Thus, if a contract is settled as a result of a two-way (gross) exchange of items that are readily convertible to cash or are derivatives, the net settlement characteristic is met. 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).
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.

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