8.4 Application to Specific Embedded Features | DART – Deloitte Accounting Research Tool

8.4.1 Features Related to an Interest Rate

8.4.1.1 Background

This section discusses the analysis of whether an embedded feature that could adjust the payments on a debt host contract that is based solely on an interest rate or interest rate index should be separated as a derivative. Examples of contractual provisions in debt contracts that should be evaluated under the guidance discussed in this section include:

Interest payments that are leveraged on the basis of market interest rates (e.g., the contractual interest rate is a multiple of a benchmark interest rate).
Interest payments that move inversely with market interest rates (e.g., when market interest rates increase, the contractual interest rate decreases).
Interest payments that are based on a tenor of a benchmark interest rate that is different from the tenor of the interest payments (e.g., a constant maturity yield).
Choose-your-rate options (e.g., the debtor can elect to switch the basis of future variable-interest-rate payments to a different benchmark interest rate).
Caps, floors, or collars on interest payments indexed to a market interest rate.
Interest rate adjustments that are contingent on the level of interest rates.
Certain put and call options that are not otherwise required to be viewed as not clearly and closely related to the debt host contract (see Section 8.4.4.3).

This section does not address features that are contingent on, or indexed to, underlyings other than an interest rate or interest rate index, including features that are indexed to both interest rates and other underlyings (see Section 8.4.1.3.2).

8.4.1.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of an embedded feature that is based solely on an interest rate or interest rate index and could adjust the cash flows of a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	It depends	The issuer must evaluate whether an interest-related feature is clearly and closely related to a debt host in accordance with the negative-yield test and the double-double test (ASC 815-15-25-26; see Section 8.4.1.3).
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	Yes	An interest-rate-related feature that adjusts the payments of a debt host contract meets the definition of a derivative (see Section 8.4.1.4).
Meets a scope exception (see Section 8.3.5)	No	No scope exception is available for features that are based solely on an interest rate or an interest rate index (see Section 8.3.5).

As shown in the table above, a debtor’s determination of whether it must bifurcate as a derivative an embedded feature that is based solely on an interest rate or interest rate index and could adjust the payments of a debt host contract tends to focus on whether the feature is considered clearly and closely related to the debt host contract unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10. Typically, such features meet the definition of a derivative and are not exempt from derivative accounting.

8.4.1.3 Clearly-and-Closely-Related Analysis

8.4.1.3.1 General

ASC 815-15

25-26 For purposes of applying the provisions of paragraph 815-15-25-1, an embedded derivative in which the only underlying is an interest rate or interest rate index (such as an interest rate cap or an interest rate collar) that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract that is considered a debt instrument is considered to be clearly and closely related to the host contract unless either of the following conditions exists:

The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment (that is, the embedded derivative contains a provision that permits any possibility whatsoever that the investor’s [the holder’s or the creditor’s] undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms).
The embedded derivative meets both of the following conditions:
1. There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract (that is, the embedded derivative contains a provision that could under any possibility whatsoever at least double the investor’s initial rate of return on the host contract).
2. For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed in (b)(1)), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.

25-27 Even though the conditions in (a) and (b) in the preceding paragraph focus on the investor’s rate of return and the investor’s recovery of its investment, the existence of either of those conditions would result in the embedded derivative not being considered clearly and closely related to the host contract by both parties to the hybrid instrument. Because the existence of those conditions is assessed at the date that the hybrid instrument is acquired (or incurred) by the reporting entity, the acquirer of a hybrid instrument in the secondary market could potentially reach a different conclusion than could the issuer of the hybrid instrument due to applying the conditions in the preceding paragraph at different points in time.

25-28 An embedded derivative that alters net interest payments based on changes in a stock price index (or another non-interest-rate index) is not addressed in paragraph 815-15-25-26.

ASC 815-15-25-26 addresses whether an embedded feature whose only underlying is an interest rate or interest rate index should be considered clearly and closely related to a debt host contract. There are two conditions in ASC 815-15-25-26: one that focuses on the investor’s recovery of its investment (the negative-yield test; see Section 8.4.1.3.3) and one that focuses on the investor’s rate of return (the double-double test; see Section 8.4.1.3.4). If either of these conditions is met, neither party to the hybrid instrument would consider the embedded derivative feature clearly and closely related to the host contract. ASC 815-15-25-26 indicates that when an entity assesses whether it meets these conditions, it should not consider the likelihood that a condition will be satisfied — the condition is met if there is any possibility whatsoever that it will be met.

8.4.1.3.2 Features That Are Indexed to Both Interest Rates and Other Underlyings

Because ASC 815-15-25-26 only applies to embedded features “in which the only underlying is an interest rate or interest rate index,” it does not apply to features that are indexed to, or contingent on, something other than an interest rate or an interest rate index, including features that are indexed to both an interest rate or interest rate index and other underlyings. An embedded put, call, or other redemption feature whose exercise is contingent on the occurrence or nonoccurrence of a specified uncertain, future event (e.g., an IPO or a change in control) would always have a second underlying (the occurrence or nonoccurrence of the specified event). Therefore, the redemption feature would only be subject to evaluation under ASC 815-15-25-26 if the event is solely related to an interest rate or an interest rate index (e.g., an embedded call option that may only be exercised when LIBOR is at or above 5 percent).

Although an embedded feature that has a payoff that is indexed to both interest rates and another underlying (e.g., an event of default, a stock price, commodity price, or the entity’s stock market capitalization) is not subject to an evaluation under ASC 815-15-25-26, such a feature would not be considered clearly and closely related to a debt host contract unless either (1) the other underlying is based on the issuer’s credit risk (see Section 8.4.2) or inflation (see Section 8.4.3) or (2) the feature is a contingent redemption feature that otherwise does not have to be separated under the guidance on such features (see Section 8.4.4).

For guidance on the evaluation of features that are indexed to underlyings other than an interest rate or interest rate index, see, for example, Sections 8.4.2 (credit-sensitive payments), 8.4.3 (inflation-indexed payments), 8.4.7 (equity-indexed payments), 8.4.8 (foreign currency features), 8.4.9.3 (commodity-indexed payments), 8.4.10 (revenue-indexed payments), and 8.4.11 (other payments contingent on underlyings other than interest rates, credit risk, or inflation).

8.4.1.3.3 Negative-Yield Test

Under the negative-yield test (i.e., ASC 815-15-25-26(a)), an embedded interest rate feature is not clearly and closely related to its debt host contract if it could contractually cause the debt to be settled in such a way that the investor would not recover substantially all of its initial recorded investment. In other words, this test might be passed if it is contractually possible that the creditor could be forced to accept a negative yield on its investment.

The debtor performs the test as of the date on which it initially recognizes the debt and does not subsequently reassess whether the test is passed.

Example 8-4

Bond With Leverage Feature

Company X invests in a $10 million 10-year bond that pays a fixed rate of 6 percent for the first two years and then pays a variable rate calculated as 14 percent minus the product of 2.5 times three-month LIBOR, without a floor, for the remaining term of the bond. If three-month LIBOR were to increase significantly, the bond might result in a negative return, which would effectively erode the bond’s principal. In that case, X may not recover substantially all of its initial investment. As a result, the negative-yield test is passed. Company X and the bond issuer should, therefore, separately account for the embedded interest rate derivative unless the entire hybrid financial instrument is recognized at fair value, with changes in fair value recognized in earnings.

In practice, the phrase “substantially all” in ASC 815-15-25-26(a) is interpreted to mean at least 90 percent of the original investment. The test is performed on an undiscounted basis. If, at inception, there is any contractual possibility whatsoever that the undiscounted contractual net cash flows received by the creditor over the life of the instrument will not be at least 90 percent of the investment recorded by the investor at inception, the negative-yield test is passed and the debtor would consider the feature not to be clearly and closely related to the debt host. Otherwise, an embedded feature that is based only on an interest rate or interest rate index would be considered clearly and closely related to its host provided that it does not pass the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4).

ASC 815-15

25-29 The condition in paragraph 815-15-25-26(a) applies only to those situations in which the investor (creditor) could be forced by the terms of a hybrid instrument to accept settlement at an amount that causes the investor not to recover substantially all of its initial recorded investment. That condition does not apply to a situation in which the terms of a hybrid instrument permit, but do not require, the investor to settle the hybrid instrument in a manner that causes it not to recover substantially all of its initial recorded investment, provided that the issuer does not have the contractual right to demand a settlement that causes the investor not to recover substantially all of its initial net investment.

If scenarios exist in which the investor contractually would not recover substantially all of its initially recorded investment, but the creditor could not be forced to accept such a settlement or could prevent such a scenario from occurring, the negative-yield test is not passed. The negative-yield test only applies to scenarios in which the creditor could be forced to accept a settlement under which it would not recover substantially all of its initial recorded investment. If the creditor has a right, but not an obligation, to settle the debt at an amount that is less than substantially all of its initially recorded investment (e.g., an embedded put option held by the creditor that has an exercise price at a significant discount to the initial investment), the negative-yield test is not passed.

Further, the negative-yield test does not reflect the risk that the debtor might breach the contract (i.e., the test is not met merely because of the risk that the debtor may default on its obligation to repay the debt). The negative-yield test only applies to scenarios in which the creditor contractually is at risk of not recovering substantially all of its initial recorded investment.

ASC 815-15

Example 10: Interest-Rate-Related Underlyings — Recovering Substantially All of an Initial Recorded Investment

Case A: Note A

55-130 If an investor in a 10-year note has the contingent option at the end of Year 2 to put it back to the issuer at its then fair value (based on its original 10-year term), the condition in paragraph 815-15-25-26(a) would not be met even though the note’s fair value could have declined so much that, by exercising the option, the investor ends up not recovering substantially all of its initial recorded investment. See paragraph 815-15-25-29.

Case B: Note B

55-131 An investor purchased from an A-rated issuer for $10 million a structured note with a $10 million principal, a 9.5 percent interest coupon, and a term of 10 years at a time when the current market rate for 10-year A-rated debt is 7 percent. Assume that the terms of the note require that, at the beginning of the third year of its term, the principal on the note be reduced to $7.1 million and the coupon interest rate be reduced to zero for the remaining term to maturity if interest rates for A-rated debt have increased to at least 8 percent by that date. That structured note would meet the condition in paragraph 815-15-25-26(a) for both the issuer and the investor because the investor could be forced to accept settlement that causes the investor not to recover substantially all of its initial recorded investment. That is, if increases in the interest rate for A-rated debt trigger the modification of terms, the investor would receive only $9 million, comprising $1.9 million in interest payments for the first 2 years and $7.1 million in principal repayment, thus not recovering substantially all of its $10 million initial net investment.

Case C: Note C

55-132 The investor purchases for $10,000,000 a structured note with a face amount of $10,000,000, a coupon of 8.9 percent, and a term of 10 years. The current market rate for 10-year debt is 7 percent given the A credit quality of the issuer. The terms of the structured note require that if the interest rate for A-rated debt has increased to at least 10 percent at the end of 2 years, the coupon on the note be reduced to zero, and the investor purchase from the issuer for $10,000,000 an additional note with a face amount of $10,000,000, a zero coupon, and a term of 3.5 years.

55-133 The structured note contains an embedded derivative that shall be accounted for separately unless a fair value election is made pursuant to paragraph 815-15-25-4.

55-134 The requirement that, if interest rates increase and the embedded derivative is triggered, the investor purchase the second $10,000,000 note for an amount in excess of its fair value (which is about $7,100,000 based on a 10 percent interest rate) generates a result that is economically equivalent to requiring the investor to make a cash payment to the issuer for the amount of the excess. As a result, the cash flows on the original structured note and the excess purchase price on the second note shall be considered in concert. The cash inflows ($10,000,000 principal and $1,780,000 interest) that will be received by the investor on the original note shall be reduced by the amount ($2,900,000) by which the purchase price of the second note is in excess of its fair value, resulting in a net cash inflow ($8,880,000) that is not substantially all of the investor’s initial net investment on the original note.

55-135 As demonstrated by this Case, if an embedded derivative requires an asset to be purchased for an amount that exceeds its fair value, the amount of the excess — and not the cash flows related to the purchased asset — shall be considered when analyzing whether the hybrid instrument can contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment under paragraph 815-15-25-26(a). Whether that purchased asset is a financial asset or a nonfinancial asset (such as gold) is not relevant to the treatment of the excess purchase price. It is noted that requiring the investor to make a cash payment to the issuer is also economically equivalent to reducing the principal on the note.

55-136 The note described could have been structured to include terms requiring that the principal of the note be substantially reduced and the coupon reduced to zero if the interest rate for A-rated debt increased to at least 10 percent at the end of 2 years. That alternative structure would clearly have required that the embedded derivative be accounted for separately, because that embedded derivative’s existence would have resulted in the possibility that the hybrid instrument could contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment.

8.4.1.3.4 Double-Double Test

Under the double-double test (i.e., ASC 815-15-25-26(b)), an embedded interest rate feature is not clearly and closely related to its debt host contract if there is a potential scenario in which the investor could achieve a rate of return on the host contract that at least doubles its initial rate of return and is twice what would otherwise be the market return. The debtor evaluates whether the double-double test is passed as of the date on which it initially recognizes the instrument. It does not subsequently reassess whether the test is passed.

This test is performed in two steps:

Step 1 — The debtor determines whether there is a possible future interest rate scenario, no matter how remote, in which the embedded feature would at least double the investor’s initial rate of return on the host contract. In making this assessment, an entity must differentiate between the return on the host contract and the return on the hybrid instrument. The initial rate of return on the host contract excludes the effects of the embedded feature. If no such scenario exists, the embedded feature would be considered clearly and closely related to its host provided that it does not pass the negative-yield test (ASC 815-15-25-26(a); see Section 8.4.1.3.3). If any such scenario exists, the debtor must proceed to step 2 below.
Step 2 — The debtor determines whether, for any of the scenarios identified in the first step for which the investor’s initial rate of return on the host contract would be doubled, the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception. If such a high return is possible, the embedded feature would not be considered clearly and closely related to its host contract. If such a high return is not possible for a feature that is based solely on an interest rate or interest rate index and the embedded feature also does not pass the negative-yield test (ASC 815-15-25-26(a); see Section 8.4.1.3.3), the embedded feature is considered clearly and closely related to the host contract.

Example 8-5

Debt With Interest Step-Up Feature

Company A invests in 30-year variable-rate debt issued by Company B. The debt is indexed to the three-month LIBOR rate plus 4 percent. As of the date of issuance, the three-month LIBOR rate was 2 percent. The debt’s terms also specify that if the three-month LIBOR rate increases to 5 percent, the debt issuer is required to pay 23 percent for the remaining term of the bonds.

If B were to issue 30-year variable-rate debt without any embedded derivatives (i.e., the interest rate reset feature), it would pay a coupon of three-month LIBOR plus 6 percent. Consequently, the initial rate of return on the host contract is 8 percent (three-month LIBOR of 2 percent plus 6 percent). Company A must determine whether the embedded derivative could at least double its initial rate of return on the host contract, which was 8 percent as of the issuance date, in any of the possible interest rate environments. When three-month LIBOR increases to 5 percent, the 23 percent interest rate feature more than doubles the initial rate of return of 8 percent on the host contract; therefore, the first condition is satisfied.

To apply the second part of ASC 815-15-25-26(b), A must determine whether, for any of the possible interest rate scenarios under which its initial rate of return on the host contract would be doubled (i.e., when three-month LIBOR is at 5 percent), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return on a contract with the same terms as the host contract. When three-month LIBOR increases to 5 percent, the rate of return on a contract with the same terms as the host contract (and involving a debtor with a credit quality similar to B’s credit quality at debt inception) would be 11 percent (three-month LIBOR of 5 percent plus 6 percent). The second condition is, therefore, also satisfied, because when three-month LIBOR increases to 5 percent, the 23 percent return generated by the embedded derivative feature in the debt is more than twice the 11 percent return (three-month LIBOR of 5 percent plus 6 percent) on the contract with the same terms as the host contract.

Both A and B would be required to account for the embedded derivative separately unless the entire hybrid financial instrument is recognized at fair value, with changes in fair value recognized in earnings. Note that ASC 815-15-25-26 indicates that when an entity assesses whether it meets one of the conditions, it should not consider the probability that the condition will be satisfied; the condition should be considered satisfied if there is any possibility whatsoever that the condition will be met. Therefore, the probability that the three-month LIBOR rate will increase to 5 percent is not relevant to the analysis of whether the condition is met. However, an entity should consider such probability when valuing any bifurcated embedded derivative.

ASC 815-15

25-37 The conditions in paragraph 815-15-25-26(b) do not apply to an embedded call option in a hybrid instrument containing a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor (the issuer or the borrower). This guidance does not affect the application of the condition in paragraph 815-15-25-26(a) or the application of paragraphs 815-15-25-41 through 25-43. In addition, this guidance does not apply to other embedded derivative features that may be present in the same hybrid instrument.

25-38 The conditions in paragraph 815-15-25-26(b) apply only to situations that meet the two conditions specified in paragraph 815-15-25-26(b)(1) through (b)(2) and for which the investor has the unilateral ability to obtain the right to receive the high rate of return specified in those paragraphs. If the embedded derivative is an option rather than a forward contract, it is important to analyze whether the investor is the holder of that option. For an embedded call option, the issuer or borrower (and not the investor) is the holder, and thus only the issuer (borrower) can exercise the option. Consequently, the investor does not have the unilateral ability to obtain the right to receive the high rate of return, which is contingent on the issuer’s exercise of the embedded call option.

If scenarios exist in which the investor could double its initial return but the debtor could prevent any such scenarios from occurring, the double-double test does not apply. For example, the double-double test does not apply if the debtor has a right, but not an obligation, to settle the debt at an amount that would pass the double-double test (e.g., an embedded call option held by the debtor that has an exercise price that potentially could double the investor’s initial return). The double-double test is passed only if scenarios exist in which the debtor contractually could not prevent a settlement that would pass the double-double test. ASC 815-15-55-25 (below) contains six examples that illustrate this concept.

ASC 815-15

55-25 Application of the guidance in paragraphs 815-15-25-37 through 25-39 to specific debt instruments is provided in the following table.

Instrument	Paragraph 815-15-25-26(b) Applicable to the Embedded Call Option?	Comments
1. An unsecured commercial loan that includes a prepayment option that permits the loan to be prepaid by the borrower at a fixed amount at any time at a specified premium over the initial principal amount of the loan.	No.	The commercial loan is prepayable only at the option of the borrower.
2. A fixed-rate debt instrument issued at a discount that is callable at par value at any time during its 10-year term.	No.	The fixed-rate debt instrument is callable at par value only by the issuer.
3. A fixed-rate 10-year bond that contains a call option that permits the issuer to prepay the bond at any time after issuance by paying the investor an amount equal to all the future contractual cash flows discounted at the then-current Treasury rate plus 45 basis points. The spread over the Treasury rate for the borrower at the issuance of the bond was 300 basis points.	No.	The fixed-rate 10-year bond is callable only at the option of the issuer.
4. A 5-year debt instrument issued at par that has a quarterly coupon equal to 15 percent minus 3 times 3-month LIBOR and that includes a call provision that allows the issuer to call the debt at any time at a specified premium over par.	No.	The instrument is callable only by the issuer, so the embedded call option feature will not be subject to the conditions in paragraph 815-15-25-26(b). However, the conditions in the paragraph are still applicable to the levered index feature of the debt.
5. A fixed rate debt instrument is issued at par and is callable at any time during its 10-year term. If the debt is called, the investor receives the greater of the par value of the debt or the market value of 100,000 shares of XYZ common stock (an unrelated entity).	No.	The instrument is callable only by the issuer, so the embedded call option feature will not be subject to the conditions in paragraph 815-15-25-26(b). However, the embedded call option is not considered clearly and closely related to the debt host contract because the payoff is based on an equity price.
6. A mortgage-backed security is issued, whereby cash flows associated with principal payments (including full or partial prepayments and related penalties) received on the related mortgage loans are passed through to the mortgage-backed security investors.	Not applicable (see comments).	Although the related mortgage loans are prepayable, and thus each contain a separate embedded call option, the mortgage-backed security itself does not contain an embedded call option. While the mortgage-backed security investor is subject to prepayment risk, the mortgage-backed security issuer has the obligation (not the option) to pass through cash flows from the related mortgage loans to the mortgage-backed security investors. Therefore, mortgage-backed securities are not within the scope of this guidance. Paragraphs 815-15-25-33 through 25-36 address the application of paragraph 815-15-25-26(b) to securitized interests in prepayable financial assets.

8.4.1.3.5 Interest Rate Caps, Floors, and Collars

ASC 815-15

25-32 Floors or caps (or collars, which are combinations of caps and floors) on interest rates and the interest rate on a debt instrument are considered to be clearly and closely related unless the conditions in either paragraph 815-15-25-26(a) or 815-15-25-26(b) are met, in which circumstance the floors or the caps are not considered to be clearly and closely related.

Caps, floors, or collars on floating-rate interest payments are considered clearly and closely related to a debt host contract unless the negative-yield test or the double-double test (ASC 815-15-25-26) is passed (see Sections 8.4.1.3.3 and 8.4.1.3.4).

Example 8-6

Debt With Embedded Floor

Company A issues five-year variable-rate debt to the public that is indexed to the LIBOR rate (LIBOR plus 1 percent). LIBOR is currently 6 percent. The investors required that A pay not less than 5 percent at any time during the term of the debt. The agreement that A will not pay an interest rate less than 5 percent on its variable-rate debt represents a floor. If A were to issue a five-year variable-rate debt without a floor, it would pay LIBOR plus 2 percent. The floor would not pass the negative-yield test (ASC 815-15-25-26(a); see Section 8.4.1.3.3) because it could not result in a failure of the investor to recover substantially all of its initial investment. The floor would not pass the double-double test (ASC-815-25-26(b); see Section 8.4.1.3.4) because it could not result in a rate of return that is more than double the initial rate of return of 8 percent (LIBOR at inception plus 2 percent). The floor, when in-the-money, will only result in a rate of 5 percent.

Example 8-7

Debt With Embedded Cap

On January 1, 20X1, Company X purchases a bond at par that pays LIBOR. The bond also incorporates an interest rate cap provision under which if LIBOR equals or exceeds 8 percent as of any interest rate reset date, X will receive a return of 10 percent. On the date on which X purchases the bond, it also could purchase at par a variable-rate bond not containing a cap that pays LIBOR minus 1 percent from a debtor that has the same credit quality as the issuer of X’s bond. As of January 1, 20X1, LIBOR is 5 percent. The bond cannot contractually be settled such that X would not recover substantially all of its initial recorded investment in the bond (i.e., the negative-yield test in ASC 815-15-25-26(a) is not passed; see Section 8.4.1.3.3). To perform the first step of the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4), X must determine whether there is any interest rate scenario, no matter how remote, under which the embedded derivative (the cap) would at least double its initial rate of return on the host contract. This analysis is summarized in the following table:

A LIBOR Interest Rate Range	B Return Reflecting the Effect of Cap	C Initial Rate of Return on Host (LIBOR Minus 1%)	D Initial Rate of Return on Host Doubled	Is the ASC 815-15-25-26(b)(1) Test Met — Is B > D?
0–7.99% 8% and up	0–7.99% 10%	4% 4%	8% 8%	No Yes

Since the first step suggests that there is a possible scenario in which X could double its initial rate of return on the host contract, X must perform the second step in ASC 815-15-25-26(b) to determine whether the embedded cap is clearly and closely related to the debt host contract. For this test, X must determine, for any of the possible interest rate scenarios identified above under which X’s initial rate of return on the host contract would be doubled, whether the embedded cap would simultaneously result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception. Company X’s analysis for this test can be summarized as follows:

A Interest Rate Scenario Identified in the ASC 815-15-25-26(b)(1) Test for Which the Cap Would at Least Double the Investor’s Initial Rate of Return on the Host Contract	B Return Reflecting the Effect of the Cap Under the Interest Rate Scenario in A	C Current Market Rate for a Contract Having the Same Terms as the Host Contract Under the Interest Rate in A (LIBOR Minus 1%)	Is the ASC 815-15-25-26(b)(2) Test Met — Is B at Least Twice C for Any Scenario?
8% and up	10%	7% and up	No

Since the second step suggests that there is no possible scenario in which the investor would achieve a rate of return that is at least twice what otherwise would be the then-current market return, the embedded cap is considered clearly and closely related to the debt host contract under the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4).

Example 8-8

Debt With LIBOR-Indexed Interest Rate Adjustment

On January 1, 20X0, an entity issues a variable-rate debt instrument at par, maturing on January 1, 20X5. The interest rate is three-month LIBOR plus 0.40 percent as long as three-month LIBOR remains at or above 6.00 percent. In periods in which three-month LIBOR drops below 6.00 percent, the interest rate on the debt is calculated as follows: three-month LIBOR plus 0.40 percent – [2 × (6.00% – 3-month LIBOR)]. The following table illustrates the interest rate on the debt under certain conditions:

For the embedded derivative to be considered clearly and closely related to the debt host, the hybrid instrument cannot contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment (ASC 815-15-25-26(a); see Section 8.4.1.3.3). In this case, it is possible for the investor in the debt to incur an unlimited negative return, thus not recovering substantially all of its original investment. Therefore, the embedded floor would not be considered clearly and closely related to the debt host.

However, if the agreement were to contain a provision that guaranteed a cumulative minimum rate of return to the investor over the life of the debt, thereby eliminating the circumstance in which the debt could contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment, the embedded derivative could not cause the investor not to recover substantially all of its initial recorded investment. For example, the agreement could contain a minimum interest rate clause such that if the defined interest rate is less than zero, negative interest accrues. However, accrued negative interest may only be applied to (1) future interest payments required under this debt or (2) the principal amount only to the extent of interest previously paid under the debt agreement, provided that any accrued interest remains at maturity of the debt. Therefore, the instrument cannot contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment. The leveraged interest rate terms and floor would be considered clearly and closely related to the debt (provided that under ASC 815-15-25-26(b)’s double-double test [see Section 8.4.1.3.4], those embedded features are clearly and closely related to the debt host). A cap on a leveraged interest rate index would be similarly analyzed under ASC 815-15-25-26 through 25-29.

8.4.1.3.6 Interest Rate Tenor Mismatch (Including Constant Maturity Rates)

The contractual interest rate of many debt securities is based on a reference index. It is not uncommon for the contractual terms of some securities to require the contractual interest rate to reset more frequently than the term of the index the securities are referenced to. One example is a debt security whose interest rate resets every six months to a 10-year index (i.e., a constant maturity rate). Such an interest rate index should be evaluated under ASC 815-15-25-26.

Example 8-9

Debt With Interest Rate Tenor Mismatch

Assume that a 30-year note has an initial yield of 4 percent and that the contractual interest rate resets semiannually to a 10-year index interest rate plus 100 basis points rather than to the six-month rate. The initial yield on a security that resets to the six-month rate, but that otherwise has terms that are identical to those of the 30-year note, is 3 percent.

Because the interest rate resets semiannually to a point further out than the next reset date on the interest rate curve (i.e., a 10-year rate vs. a six-month rate), there are possible future interest rate scenarios under which the initial rate of return on the host contract and the then-current market rate would be doubled. The application of the double-double test (ASC 815-15-25-26(b); see Section 8.4.1.3.4) is shown in the table below.

Step 1: Is there a possible interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract?

Yes. It is possible that the 10-year index rate could be more than double the investor’s initial rate of return on the host contract, which is 3 percent.

Step 2: For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled, could the embedded derivative at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception?

Yes. It is possible that the 10-year index rate could be more than double the six-month rate on the same date; therefore, the embedded derivative could result in a rate of return that is at least twice the then-current market return for a contract that has the same terms as the host contract, which resets to the current six-month rate. Note that it is irrelevant whether it is probable that the 10-year rate will rise to more than twice the six-month rate.

Because both conditions in ASC 815-15-25-26(b) are met, the embedded interest rate index is not considered clearly and closely related to the debt host of the 30-year note. If the instrument contains a cap that is less than double the initial rate of return on the host contract, however, the conditions in ASC 815-15-25-26(b) would not be met.

8.4.1.3.7 Choose-Your-Rate Option

Variable-rate credit facilities often include an option for the debtor to change the interest rate index that is used as the basis for calculating interest rate payments on outstanding debt (e.g., an option to switch from one benchmark interest rate to another benchmark interest rate). Such a feature is clearly and closely related to its debt host contract unless the negative-yield test or the double-double test (ASC 815-40-15-26) is passed (see Sections 8.4.1.3.3 and 8.4.1.3.4, respectively).

8.4.1.3.8 Examples

ASC 815-15-55 contains additional illustrative examples of the application of ASC 815-15-25-26.

8.4.1.4 Derivative Analysis

The table below presents an analysis of whether an embedded feature that is based solely on an interest rate or interest rate index and could adjust the payments of a debt host contract meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	An embedded feature that could adjust the payments of a debt host contract solely on the basis of an interest rate or interest rate index typically has both an underlying (i.e., the interest rate or interest rate index) and a notional amount (i.e., the amount on which the interest rate adjustment is based, such as the debt’s outstanding amount) or payment provision (e.g., a fixed cash payment contingent on an interest rate or interest rate index).
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the interest-rate-related feature on a stand-alone basis without the host contract). Generally, an embedded feature that could adjust the cash flows of a debt host contract solely on the basis of an interest rate or interest rate index has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in interest rates (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	Yes	An embedded feature that adjusts the payments of a debt host contract solely on the basis of an interest rate or interest rate index meets the net settlement condition (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 feature’s notional amount).

As shown in the table above, an embedded feature that is based solely on an interest rate or interest rate index and could adjust the payments of a debt host contract typically meets the definition of a derivative. Therefore, the analysis of whether it must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract (see Section 8.4.1.3) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).

8.4.2 Credit-Risk-Related Features

8.4.2.1 Background

Examples of contractual provisions in debt contracts that could adjust payments on the basis of a measure of credit risk include:

A provision that requires the debtor to pay additional interest (e.g., 2 percent per annum) upon the debtor’s event of default.
A feature that adjusts interest payments on the basis of a measure of the debtor’s creditworthiness (e.g., a table that specifies different margins over a benchmark interest rate on the basis of a measure of the debtor’s working capital).
A feature that adjusts principal or interest payments on the basis of the credit risk of a third party.

This section does not address features that could accelerate the repayment of the outstanding amount of the debt in cash upon the occurrence or nonoccurrence of a specified event such as an event of default. Such features should be evaluated as contingent redemption features (see Section 8.4.4).

8.4.2.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a credit-risk-related feature embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	It depends	A credit-sensitive payment that is based solely on the creditworthiness of the debtor is clearly and closely related to a debt host (see Section 8.4.2.3). However, the creditworthiness of a third party is not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). The fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	Yes	A credit-risk-related feature that adjusts the payments of a debt host contract meets the definition of a derivative (see Section 8.4.2.4).
Meets a scope exception (see Section 8.3.5)	It depends	Typically, no specific scope exception is available for a credit-risk-related feature that is based on the debtor’s creditworthiness (see Section 8.3.5). However, in some situations the scope exception for financial guarantee contracts may apply (see Section 8.4.2.5).

As shown in the table above, a debtor’s determination of whether an embedded credit-risk-related feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract (see the next section) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3). If the credit-risk-related feature is based on the credit risk of a third party, the debtor should also evaluate whether the feature can be net settled (see Section 8.4.2.4) and whether it qualifies for the scope exception for financial guarantee contracts (see Section 8.4.2.5).

8.4.2.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-46 The creditworthiness of the debtor and the interest rate on a debt instrument shall be considered to be clearly and closely related. Thus, for debt instruments that have the interest rate reset in the event of any of the following conditions, the related embedded derivative shall not be separated from the host contract:

Default (such as violation of a credit-risk-related covenant)
A change in the debtor’s published credit rating
A change in the debtor’s creditworthiness indicated by a change in its spread over U.S. Treasury bonds.

25-47 If an instrument incorporates a credit risk exposure that is different from the risk exposure arising from the creditworthiness of the obligor under that instrument, such that the value of the instrument is affected by an event of default or a change in creditworthiness of a third party (that is, an entity that is not the obligor), then the economic characteristics and risks of the embedded credit derivative are not clearly and closely related to the economic characteristics and risks of the host contract, even though the obligor may own securities issued by that third party. This guidance shall be applied to all other arrangements that incorporate credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. This guidance does not affect the accounting for a nonrecourse debt arrangement (that is, a debt arrangement in which, in the event that the debtor does not make the payments due under the loan, the creditor has recourse solely to the specified property pledged as collateral).

A credit-sensitive payment is considered clearly and closely related to a debt host contract under ASC 815-15-25-46 and 25-47 if it is triggered by, and directionally consistent with, a measure of the debtor’s creditworthiness, such as one or more of the following:

The debtor’s failure to pay amounts due on a timely basis (e.g., additional interest on late payments).
The debtor’s failure to comply with credit-risk-related debt covenants (e.g., additional interest that becomes payable if there is a material adverse change in the debtor’s creditworthiness).
A change in the debtor’s published credit rating (e.g., additional interest that becomes payable upon a credit rating downgrade).
A change in observable interest rate spreads over a risk-free interest rate (e.g., U.S. Treasury rates) for debt instruments with similar credit risk (e.g., an interest rate that varies on the basis of observable credit spreads on identical or similar debt securities issued by the debtor or other similar debtors).
A change in another measure of the debtor’s creditworthiness (e.g., a specified interest margin that varies on the basis of a measure of the debtor’s working capital).

However, a provision that requires an adjustment on the basis of the creditworthiness of a third party (e.g., the third party’s default) is not clearly and closely related to a host debt contract.

Debt contracts often contain provisions that require the debtor to pay additional interest upon the occurrence of an “event of default.” To determine whether such a provision is clearly and closely related to the debt host, the debtor must evaluate how the debt terms define an event of default. The table below discusses common situations that may be described as events of default and whether such triggering events would be considered clearly and closely related to a debt host.

Triggering Event	Clearly and Closely Related?
Any representation or warranty made by the debtor is not correct	Yes
The debtor’s failure to perform or comply with financial or nonfinancial covenants	Yes, unless the covenants include items that do not affect the issuer’s credit risk
The debtor’s bankruptcy or insolvency	Yes
Cross default on the debtor’s other indebtedness	Yes, unless the default on the other indebtedness arises from events that are not credit-related
Invalidity or failure of debtor to maintain loan or collateral documents	Yes
The debtor’s nonpayment of principal or interest when due	Yes
Judgments or orders against the debtor exceeding a specific amount	Yes
Revocation of the debtor’s license or permit to perform business operations that results in a material adverse effect	Yes
Criminal events of the debtor	Yes
A change of control of the debtor	No
Key-person event	Depends on facts and circumstances
The debtor suffers a credit rating downgrade	Yes
An observable increase in the debtor’s current interest rate spread over a risk-free interest rate	Yes

Example 8-10

Debt With Interest Rate Adjustment

Company ABC is rated BBB. Company ABC issues $100 million in 8 percent fixed-rate bonds. The bonds include a provision that requires the interest rate to reset to 10 percent if ABC’s credit rating is downgraded to a single B at any time during the term of the bonds. The embedded derivative that resets the interest rate of the bonds is clearly and closely related to the debt host because it is based on the issuer’s credit rating.

However, if ABC’s bonds include a provision that requires the interest rate to reset to 10 percent if Company XYZ’s (an unrelated party’s) credit rating is downgraded to a single B at any time during the term of the bonds, the reset feature is not clearly and closely related to the debt host.

ASC 815-15

Case A: Credit-Linked Note

55-103 Entity A issues to an investor a fixed-rate, 10-year, $10 million credit-linked note that provides for periodic interest payments and the repayment of principal at maturity. However, upon default of a specified reference security (an Entity X subordinated debt obligation) the redemption value of the note may be zero or there may be some claim to the recovery value of the reference security (depending on the terms of the specific arrangement). Generally, the term reference security refers to the security whose credit rating or default determines the cash flows under a credit derivative. Usually, the terms of credit-linked notes explicitly reference Committee on Uniform Security Identification Procedures (CUSIP) numbers of securities in the marketplace. In an event of default of the specified reference security, there is no recourse to the general credit of the obligor (Entity A). In exchange for accepting the default risk of the reference security, the note entitles the investor to an enhanced yield. The transaction results in the investor selling credit protection and Entity A buying credit protection.

55-104 The credit-linked note includes an embedded credit derivative. The credit risk exposure of the reference security (Entity X) and the risk exposure arising from the creditworthiness of the obligor (Entity A) are not clearly and closely related. Thus, the economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the debt host contract and, accordingly, the criterion in paragraph 815-15-25-1(a) is met.

55-105 Paragraph 815-15-25-6 explains that the fair value election for hybrid financial instruments that otherwise would require bifurcation does not apply to hybrid financial instruments that are described in paragraph 825-10-50-8, which include insurance contracts as discussed in Section 944-20-15, other than financial guarantees and investment contracts.

55-106 Consideration should be given to whether the embedded derivative could possibly not be subject to this Topic as a financial guarantee under paragraph 815-10-15-58 and, in that circumstance, the embedded derivative would not warrant bifurcation.

Case M: Credit-Sensitive Bond

55-200 A credit-sensitive bond has a coupon rate of interest that resets based on changes in the issuer’s credit rating.

55-201 A credit-sensitive bond can be viewed as combining a fixed-rate bond with a conditional exchange contract (or option contract) that entitles the investor to a higher rate of interest if the credit rating of the issuer declines. Because the creditworthiness of the debtor and the interest rate on a debt instrument are clearly and closely related, the embedded derivative should not be separated from the host contract.

8.4.2.4 Derivative Analysis

The table below presents an analysis of whether a credit-risk-related embedded feature that could adjust the payments on a debt host contract meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	A credit-risk-related feature that could adjust the payments of a debt host contract generally has both an underlying (e.g., an event of default or the issuer’s credit rating) and a notional amount (i.e., the amount on which the adjustment is based, such as the debt’s outstanding amount) or payment provision (e.g., a fixed cash payment).
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the credit-risk-related feature on a stand-alone basis without the host contract). Generally, a credit-risk-related feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in credit risk (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	Yes	A credit-risk-related embedded feature that adjusts the payments of a debt host contract meets the net settlement condition (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 feature’s notional amount).

As shown in the table above, a credit-risk-related embedded feature that could adjust the payments of a debt host contract on the basis of the debtor’s creditworthiness meets the definition of a derivative. Therefore, the analysis of whether such a feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract (see Section 8.4.2.3) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).

8.4.2.5 Scope Exception for Financial Guarantee Contracts

ASC 815-10

15-58 Financial guarantee contracts are not subject to this Subtopic only if they meet all of the following conditions:

They provide for payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a nonderivative contract, either:
1. At prespecified payment dates
2. At accelerated payment dates as a result of either the occurrence of an event of default (as defined in the financial obligation covered by the guarantee contract) or notice of acceleration being made to the debtor by the creditor.
Payment under the financial guarantee contract is made only if the debtor’s obligation to make payments as a result of conditions as described in (a) is past due.
The guaranteed party is, as a precondition in the contract (or in the back-to-back arrangement, if applicable) for receiving payment of any claim under the guarantee, exposed to the risk of nonpayment both at inception of the financial guarantee contract and throughout its term either through direct legal ownership of the guaranteed obligation or through a back-to-back arrangement with another party that is required by the back-to-back arrangement to maintain direct ownership of the guaranteed obligation.

In contrast, financial guarantee contracts are subject to this Subtopic if they do not meet all three criteria, for example, if they provide for payments to be made in response to changes in another underlying such as a decrease in a specified debtor’s creditworthiness.

Credit Derivatives

55-45 Many different types of contracts are indexed to the creditworthiness of a specified entity or group of entities, but not all of them are derivative instruments. Credit-indexed contracts that have certain characteristics described in paragraph 815-10-15-58 are guarantees and are not subject to the requirements of this Subtopic. Credit-indexed contracts (often referred to as credit derivatives) that do not have the characteristics necessary to qualify for the exception in that paragraph are subject to the requirements of this Subtopic. One example of the latter is a credit-indexed contract that requires a payment due to changes in the creditworthiness of a specified entity even if neither party incurs a loss due to the change (other than a loss caused by the payment under the credit-indexed contract).

As noted in ASC 815-15-55-106 (see Section 8.4.2.3), a debtor should consider whether an embedded credit derivative in a credit-linked note qualifies for the scope exception for certain financial guarantee contracts in ASC 815-10-15-58. To qualify for this scope exception, the embedded feature must meet all of the conditions in ASC 815-10-15-58. For example, the scope exception is only available if the guaranteed party (i.e., the issuer of the credit-linked note) as a precondition for payment (e.g., a reduction in the contractually required cash flows of the credit-linked note) is contractually required to either (1) hold the third-party debt or (2) be exposed to the risk of nonpayment on the third-party debt through a back-to-back arrangement with another party under which that other party is contractually required to hold the third-party debt. Further, the scope exception is only available if the feature solely reimburses the guaranteed party (i.e., the issuer of the credit-linked note) for overdue payments on the third-party debt. For example, the scope exception is not available if the guarantee payments are made on the basis of (1) events of default other than past-due payments on the third-party debt or (2) changes in the credit rating of the third-party debtor.

8.4.3 Inflation-Indexed Payments

8.4.3.1 Background

This section discusses the analysis of whether an inflation-indexed payment feature embedded in a debt host contract should be separated as a derivative (e.g., inflation-linked bonds). The discussion does not address features that could accelerate the repayment of the outstanding amount of the debt in cash upon the occurrence or nonoccurrence of a specified event (e.g., an acceleration feature that is triggered by a specified measure of inflation). Such features should be evaluated as contingent redemption features (see Section 8.4.4).

8.4.3.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of an inflation-indexed payment feature embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	It depends	The rate of inflation in the economic environment for the currency in which the debt is denominated is clearly and closely related to the debt host unless the feature is leveraged (see Section 8.4.3.3). The rate of inflation in other economic environments is not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	Yes	An inflation-indexed payment feature that adjusts the payments of a debt host contract meets the definition of a derivative (see Section 8.4.3.4).
Meets a scope exception (see Section 8.3.5)	No	No specific scope exception is available for inflation-indexed payment features embedded in debt host contracts (see Section 8.3.5).

As shown in the table above, a debtor’s determination of whether an inflation-indexed feature that could adjust the payments of a debt host contract must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract (see Section 8.4.3.3) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3). Typically, such features meet the definition of a derivative (see Section 8.4.3.4) and are not exempt from the scope of derivative accounting.

8.4.3.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-50 The interest rate and the rate of inflation in the economic environment for the currency in which a debt instrument is denominated shall be considered to be clearly and closely related. Thus, nonleveraged inflation-indexed contracts (debt instruments, capitalized lease obligations, pension obligations, and so forth) shall not have the inflation-related embedded derivative separated from the host contract.

Under ASC 815-15-25-50, the indexation of principal or interest payments to an inflation rate (e.g., U.S. CPI or U.K. RPI) is considered clearly and closely related to a debt host contract if (1) the inflation rate is appropriate for the economic environment for the currency in which the debt is denominated and (2) the feature is not leveraged (e.g., interest payments that are computed on the basis of two times CPI would not be considered clearly and closely related to a debt host contract). For example, payments indexed to an unleveraged measure of U.S. CPI would be considered clearly and closely related to USD-denominated debt. Conversely, the rate of inflation in a different economic environment (e.g., EUR-denominated debt that has principal or interest payments indexed to U.S. CPI) is not clearly and closely related to the debt host.

Example 8-11

Debt With Embedded Inflation Index Feature

A U.S. company issues U.S. dollar–denominated bonds. There is an embedded inflation index that requires the bond issuer to pay the change in the Mexican CPI every two years. The embedded inflation-indexed derivative is not clearly and closely related to the bond because it is not the rate of inflation of the United States, the economic environment in which the bond was issued. However, if the bond issuer was required to pay the change in U.S. CPI every two years, the embedded derivative would be clearly and closely related and, therefore, would not need to be accounted for separately.

ASC 815-15

Case N: Inflation Bond

55-202 An inflation bond has a contractual principal amount that is indexed to the inflation rate but cannot decrease below par; the coupon rate is typically below that of traditional bonds of similar maturity.

55-203 An inflation bond can be viewed as a fixed-rate bond for which a portion of the coupon interest rate has been exchanged for a conditional exchange contract (or option contract) indexed to the consumer price index, or other index of inflation in the economic environment for the currency in which the bond is denominated, that entitles the investor to payment of additional principal based on increases in the referenced index. Such rates of inflation and interest rates on the debt instrument are considered to be clearly and closely related. Therefore, the embedded derivative should not be separated from the host contract.

8.4.3.4 Derivative Analysis

The table below presents an analysis of whether an inflation-indexed feature that could adjust the cash flows of a debt host contract meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	An inflation-indexed payment feature that could adjust the payments of a debt host contract has both an underlying (i.e., the applicable measure of inflation, such as the change in CPI) and a notional amount (i.e., the amount on which the adjustment is based, such as the debt’s outstanding amount) or payment provision (e.g., a fixed cash payment).
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the inflation-indexed feature on a stand-alone basis without the host contract). Generally, an inflation-indexed feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the inflation rate (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	Yes	A feature that adjusts the payments of a debt host contract on the basis of an inflation index meets the net settlement condition (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 feature’s notional amount).

As shown in the table above, an inflation-indexed feature embedded in a debt host contract typically meets the definition of a derivative. Therefore, the analysis of whether such a feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract (see Section 8.4.3.3) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).

8.4.4 Call, Put, and Other Redemption Features

8.4.4.1 Background

Debt contracts often contain features that could permit the issuer to call (or prepay) the outstanding amount or the holder to put (or accelerate the repayment of) the outstanding amount. Debt contracts might also contain features that trigger an acceleration of the due date for the repayment of the debt upon the occurrence or nonoccurrence of a specified event or events (e.g., an event of default or change of control).

8.4.4.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of redemption features embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	It depends	The debtor should evaluate whether the redemption feature is clearly and closely related to the debt host under the four-step decision sequence in ASC 815-15-25-41 (see Section 8.4.4.3).
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). The fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	Yes	A redemption feature embedded in a debt host meets the definition of a derivative irrespective of whether the debt host contract is readily convertible to cash (see Section 8.4.4.4).
Meets a scope exception (see Section 8.3.5)	No	There is no specific scope exception for redemption features embedded in a debt host.

As shown in the table above, a debtor’s determination of whether a redemption feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract (see the next section) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3). Such features meet the definition of a derivative (see Section 8.4.4.4) and are not exempt from the scope of derivative accounting.

8.4.4.3 Clearly-and-Closely-Related Analysis

ASC Master Glossary

Prepayable

Able to be settled by either party before its scheduled maturity.

ASC 815-15

25-41 Call (put) options that do not accelerate the repayment of principal on a debt instrument but instead require a cash settlement that is equal to the price of the option at the date of exercise would not be considered to be clearly and closely related to the debt instrument in which it is embedded.

25-42 The following four-step decision sequence shall be followed in determining whether call (put) options that can accelerate the settlement of debt instruments shall be considered to be clearly and closely related to the debt host contract:

Step 1: Is the amount paid upon settlement (also referred to as the payoff) adjusted based on changes in an index? If yes, continue to Step 2. If no, continue to Step 3.

Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, then that embedded feature shall be analyzed further under Steps 3 and 4.

Step 3: Does the debt involve a substantial premium or discount? If yes, continue to Step 4. If no, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.

Step 4: Does a contingently exercisable call (put) option accelerate the repayment of the contractual principal amount? If yes, the call (put) option is not clearly and closely related to the debt instrument. If not contingently exercisable, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.

ASC 815-15-25-41 and 25-42 address whether embedded call or put options are clearly and closely related to a debt host contract and apply to all features that can accelerate the settlement of a debt instrument whether such acceleration is optional or mandatory and regardless of how such features are described in the debt’s contractual terms. ASC 815-15-25-42 identifies four steps that should be performed in the analysis of whether a feature that can accelerate the settlement of a debt instrument is clearly and closely related to a debt host contract:

In practice, a discount or premium that is 10 percent or more is considered “substantial” in the analysis performed under step 3. In determining whether a substantial premium or discount exists, an entity should compare the debt’s initial net carrying amount to the potential payoff if the embedded call, put, or other redemption feature is triggered. Accordingly, an entity should base its analysis on the amount allocated to the debt for accounting purposes rather than the total cash proceeds (e.g., if debt was issued with detachable warrants, the amount allocated to the warrants could cause a discount on the debt). Nevertheless, an entity should not consider a discount that results from one of the following in its determination of whether the debt involves a substantial discount or premium under ASC 815-15-25-42:

Third-party debt issuance costs that have been deducted from the initial carrying amount (see Section 5.3.3).
A discount that results from the separation of an embedded derivative under ASC 815-15.

An entity should consider the payoff of the embedded feature being analyzed in determining whether the debt instrument was issued at a substantial premium or discount. For example, if a debt instrument that was issued at par contains a put option that allows the investor to redeem the instrument at 112 percent of par value, the debt instrument would be considered to involve a substantial premium. Similarly, if a debt instrument was issued at 90 percent of par and is redeemable at par, the debt is considered to involve a substantial discount. However, unpaid accrued interest does not form part of the analysis of whether a substantial premium or discount exists.

The following table outlines and illustrates the application of the four steps in ASC 815-15-25-42:

Steps	Examples of Terms That Would Result in a “Yes” Answer	Examples of Terms That Would Result in a “No” Answer
“Step 1: Is the amount paid upon settlement (also referred to as the payoff) adjusted based on changes in an index? If yes, continue to Step 2. If no, continue to Step 3.”	The principal amount is adjusted for changes in the price of gold. The principal amount is adjusted for changes in a stock market index. The principal amount is adjusted to reflect changes in inflation rates (e.g., CPI). The principal amount is adjusted on the basis of the issuer’s earnings or EBITDA.	The payoff is a fixed principal amount plus accrued interest. The payoff is a fixed principal amount plus a premium that decreases ratably as the instrument approaches maturity.
“Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, then that embedded feature shall be analyzed further under Steps 3 and 4.”	Commodity-linked payoff (see Section 8.4.9.3). Equity-linked payoff (see Section 8.4.7.3), such as debt that is callable by the issuer at par plus 5 percent of the change in S&P 500. Payoff linked to a credit risk exposure that is different from the borrower’s credit risk exposure (see Section 8.4.2.3).	Payoff directly linked to changes in the borrower’s credit rating (see Section 8.4.2.3). Nonleveraged inflation-indexed contracts where the inflation rate is in the economic environment for the currency in which the debt is denominated (see Section 8.4.3.3).
“Step 3: Does the debt involve a substantial premium or discount? If yes, continue to Step 4. If no, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable” (see Section 8.4.1).	Fixed-rate debt issued at a 12 percent discount to par and contingently puttable at par. Fixed-rate debt issued at par that is contingently puttable for 110 percent of par.	Debt puttable at par issued at a 6 percent discount to par. Debt issued at a 3 percent discount to par that is callable upon an IPO at par plus accrued and unpaid interest.
“Step 4: Does a contingently exercisable call (put) option accelerate the repayment of the contractual principal amount? If yes, the call (put) option is not clearly and closely related to the debt instrument. If not contingently exercisable, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable” (see Section 8.4.1).	Convertible debt with a redemption feature that permits the investor to put the debt if an IPO occurs. Debt with a redemption option that is exercisable by either the investor or the issuer upon a change in control. Debt with a redemption option that is exercisable upon a change in interest of at least 150 basis points.	The embedded option is exercisable at any time. The embedded option is exercisable at the anniversary date of the issuance of the debt.

As noted in steps 2, 3, and 4 of the decision sequence in ASC 815-15-25-42, an entity might be required to consider the applicability of ASC 815-15-25-26 to an embedded call, put, or other redemption feature. ASC 815-15-25-26 applies to embedded derivatives “in which the only underlying is an interest rate or interest rate index . . . that alters net interest payments that otherwise would be paid or received on an interest-bearing [debt] host contract” (see Section 8.4.1.3). An option that can be exercised only upon the occurrence or nonoccurrence of a specified event (e.g., an IPO or a change in control at the issuer) would always have a second underlying (the occurrence or nonoccurrence of the specified event). The existence of this second underlying would exclude such a contract from the scope of ASC 815-15-25-26 unless the event is solely related to interest rates (e.g., a call that may only be exercised when LIBOR is at or above 5 percent) because the underlying would never be only an interest rate or interest rate index (see Section 8.4.1.3.2).

Example 8-12

Debt That Is Puttable Upon a Change in Control

Entity A issues a 10-year note at par, which becomes puttable to the issuer at 102 percent of par plus accrued interest, if a change in control occurs at A.

As shown in the table below, A must apply the four-step decision sequence in ASC 815-15-25-42 to evaluate whether the embedded put option is clearly and closely related to the debt host.

Example	Indexed Payoff? (Steps 1 and 2)	Substantial Discount or Premium? (Step 3)	Contingently Exercisable? (Step 4)	Embedded Option Clearly and Closely Related?
Debt issued at par is puttable at 102 percent of par, plus accrued interest, in the event of a change in control at A.	No. The amount paid upon settlement is not “adjusted based on changes in an index.” The payoff amount is fixed at 102 percent of par, plus accrued interest.	No. The debt is issued at par and puttable for a premium that is not substantial.	N/A. Analysis is not required because the answer to step 3 is no (i.e., no substantial discount or premium).	The embedded put option is clearly and closely related to the debt host. ASC 815-15-25-26 does not apply, because the change in control is considered a second underlying that is not an interest rate or an interest rate index.

Example 8-13

Interest Make-Whole Premium That Becomes Payable Upon Exercise of Call Option

Entity X has issued a debt security, which includes a call option that permits X to prepay the outstanding amount of principal and accrued interest at any time before the debt’s maturity. If X calls the debt security before its maturity date, it is required to also pay an interest make-whole premium equal to the present value of the debt’s remaining interest cash flows discounted at a fixed spread over the current U.S. Treasury rate as of the date on which the debt is settled. However, X could not be required to pay an interest make-whole premium in excess of 5 percent of the principal amount.

The interest make-whole premium is considered an integral component of the call option; it is not a distinct embedded feature that requires separate evaluation under ASC 815-15 (see Section 8.2.3). When assessing whether the call option is clearly and closely related to its host, the issuer first should look to the four-step decision sequence in ASC 815-15-25-42.

Example	Indexed Payoff? (Steps 1 and 2)	Substantial Discount or Premium? (Step 3)	Contingently Exercisable? (Step 4)	Embedded Option Clearly and Closely Related?
Debt security issued at par is callable at par plus an interest make-whole premium that may not exceed 5 percent of the principal amount.	Yes. The amount paid upon settlement is adjusted on the basis of changes in the then-current U.S. Treasury rate. The calculation of the interest make-whole premium includes the U.S. Treasury rate. The payoff is not, however, indexed to an underlying other than interest rates or credit risk.	No. The debt was issued at par and the interest make-whole premium cannot exceed 5 percent of the principal amount.	N/A. Analysis is not required because the answer to the question in step 3 is no (i.e., no substantial discount or premium).	ASC 815-15-25-26 applies since the interest make-whole premium is indexed to an interest rate. Under ASC 815-15-25-26(a), there is no circumstance in which the investor would not contractually recover its initial investment if the issuer exercises the call option because the repayment amount will exceed the principal amount, and the debt was issued at par. ASC 815-15-25-26(b) does not apply. ASC 815-15-25-37 states that this condition does “not apply to an embedded call option in a hybrid instrument containing a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor.” The embedded call option, including the interest make-whole provision, is clearly and closely related to the debt host.

ASC 815-15

55-13 The following table demonstrates the application of the four-step decision sequence in paragraph 815-15-25-42 for determining whether call options and put options that can accelerate the settlement of debt instruments should be considered to be clearly and closely related to the debt host contract under the criterion in paragraph 815-15-25-1(a).

Instrument	Indexed Payoff? (Steps 1 and 2)	Substantial Discount or Premium? (Step 3)	Contingently Exercisable? (Step 4)	Embedded Option Clearly and Closely Related?
1. Debt that is issued at a substantial discount is callable at any time during its 10-year term. If the debt is called, the investor receives the par value of the debt plus any unpaid and accrued interest.	No.	Yes.	No.	The embedded call option is clearly and closely related to the debt host contract because the payoff is not indexed, and the call option is not contingently exercisable.
2. Debt that is issued at par is callable at any time during its term. If the debt is called, the investor receives the greater of the par value of the debt or the market value of 100,000 shares of XYZ common stock (an unrelated entity).	Yes, based on an equity price.	N/A. Analysis not required.	N/A. Analysis not required.	The embedded call option is not clearly and closely related to the debt host contract because the payoff is indexed to an equity price.
3. Debt that is issued at par is puttable if the Standard and Poor’s S&P 500 Index increases by at least 20 percent. If the debt is put, the investor receives the par amount of the debt adjusted for the percentage increase in the S&P 500.	Yes, based on an equity index (S&P 500).	N/A. Analysis not required.	N/A. Analysis not required.	The embedded put option is not clearly and closely related to the debt host contract because the payoff is indexed to an equity price.
4. Debt that is issued at a substantial discount is puttable at par if London Interbank Offered Rate (LIBOR) either increases or decreases by 150 basis points.	No.	Yes.	Yes, contingent on a movement of LIBOR of at least 150 basis points.	The put option is not clearly and closely related to the debt host contract because the debt was issued at a substantial discount and the put option is contingently exercisable.
5. Debt that is issued at a substantial discount is puttable at par in the event of a change in control.	No.	Yes.	Yes, contingent on a change in control.	The put option is not clearly and closely related to the debt host contract because the debt was issued at a substantial discount and the put option is contingently exercisable.
6. Zero coupon debt is issued at a substantial discount and is callable in the event of a change in control. If the debt is called, the issuer pays the accreted value (calculated per amortization table based on the effective interest rate method).	No.	Yes.	Yes, contingent on a change in control, but since the debt is callable at accreted value, the call option does not accelerate the repayment of principal.	The call option is clearly and closely related to the debt host contract. Although the debt was issued at a substantial discount and the call option is contingently exercisable, the call option does not accelerate the repayment of principal because the debt is callable at the accreted value.
7. Debt that is issued at par is puttable at par in the event that the issuer has an initial public offering.	No.	No.	N/A. Analysis not required.	The embedded put option is clearly and closely related to the debt host contract because the debt was issued at par (not at a substantial discount) and is puttable at par. Paragraph 815-15-25-26 does not apply.
8. Debt that is issued at par is puttable if the price of the common stock of Entity XYZ (an entity unrelated to the issuer or investor) changes by 20 percent. If the debt is put, the investor will be repaid based on the value of Entity XYZ’s common stock.	Yes, based on an equity price (price of Entity XYZ’s common stock).	N/A. Analysis not required.	N/A. Analysis not required.	The embedded put option is not clearly and closely related to the debt host contract because the payoff is indexed to an equity price.
9. Debt is issued at a slight discount and is puttable if interest rates move 200 basis points. If the debt is put, the investor will be repaid based on the S&P 500.	Yes, based on an equity index (S&P 500).	N/A. Analysis not required.	N/A. Analysis not required.	The embedded put option is not clearly and closely related to the debt host contract because the payoff is based on an equity index.

8.4.4.4 Derivative Analysis

8.4.4.4.1 General

The table below presents an analysis of whether a redemption feature embedded in a debt host contract meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	A redemption feature has both an underlying (interest rates and, if applicable, the occurrence or nonoccurrence of any exercise contingency and any other underlyings that adjust the redemption amount) and a notional amount (the debt’s principal amount) or payment provision.
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the redemption feature on a stand-alone basis without the host contract). Generally, a redemption feature has an initial net investment that is smaller than would be required for a direct investment that pays the redemption amount (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	Yes	The potential settlement that would occur upon the exercise of the redemption feature in a debt host contract always meets the net settlement condition because neither party is required to deliver an asset that is associated with the underlying (see Section 8.4.4.4.2).

As shown in the table above, a redemption feature embedded in a debt host contract meets the definition of a derivative. Therefore, the analysis of whether such a feature must be bifurcated as a derivative tends to focus on whether the feature is considered clearly and closely related to the debt host contract (see Section 8.4.4.3) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).

8.4.4.4.2 Net Settlement Analysis

ASC 815-10

Net Settlement of a Debt Instrument Through Exercise of an Embedded Put Option or Call Option

15-107 The potential settlement of the debtor’s obligation to the creditor that would occur upon exercise of a put option or call option embedded in a debt instrument meets the net settlement criterion as discussed beginning in paragraph 815-10-15-100 because neither party is required to deliver an asset that is associated with the underlying. Specifically:

The debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option.
The creditor does not receive an asset associated with the underlying.

15-108 The guidance in the preceding paragraph shall be applied under both of the following circumstances:

When applying paragraph 815-15-25-1(c) to a put option or call option (including a prepayment option) embedded in a debt instrument
When analyzing the net settlement criterion (see guidance beginning in paragraph 815-10-15-100) for a freestanding call option held by the debtor on its own debt instrument and for a freestanding put option issued by the debtor on its own debt instrument.

15-109 The guidance in paragraph 815-10-15-107 shall not be applied under either of the following circumstances:

To put or call options that are added to a debt instrument by a third party contemporaneously with or after the issuance of a debt instrument. (In that circumstance, see paragraph 815-10-15-6.)
By analogy to an embedded put or call option in a hybrid instrument that does not contain a debt host contract.

ASC 815-10-15-107 through 15-109 indicate that the potential settlement of a debtor’s obligation to the creditor that would occur upon the exercise of a put option or call option (including a prepayment option) embedded in a debt instrument meets the net settlement condition in ASC 815-10-15-100, which states, in part, that “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.”

Accordingly, a call, put, or other redemption feature that is embedded in a debt host meets the net settlement characteristic in the definition of a derivative irrespective of whether the debt host contract is readily convertible to cash. For instance, such a feature is considered to meet the net settlement characteristic even if it is embedded in a loan or debt security that does not have an observable price. Further, a call, put, or other redemption feature embedded in a debt host meets the net settlement characteristic even if it is settled in a form other than cash.

Traditionally, the settlement of a debt obligation upon the exercise of a put or call results in the creditor’s receipt of cash in exchange for tendering the debt obligation. However, in some circumstances, the debtor either is required or has the option to settle the redemption by delivering a number of shares of its own stock with a value equal to a predetermined dollar amount. An embedded redemption feature in a hybrid financial instrument with a debt host that may be settled with the issuer’s shares always meets the net settlement characteristic under the guidance in ASC 815-10-15-107 on put or call options in debt host contracts (see also Section 8.4.7.2.5). In the evaluation under ASC 815-10-15-107(b) of a share-settled put, call, or redemption feature embedded in a debt host contract, the assets being delivered to the holder upon the settlement of the feature are shares of the issuer. Such shares are not associated with the embedded feature’s underlying because the monetary value of the shares to be delivered does not vary on the basis of the share price. In other words, the holder is indifferent to changes in value of any of the equity shares until the feature is settled. Therefore, the net settlement criterion is met regardless of whether the underlying shares are readily convertible to cash. The guidance in ASC 815-10-15-107 through 15-109 does not apply to calls, puts, and other redemption features that are embedded in equity host contracts.

Example 8-14

Notes That Are Automatically Converted Into Shares Upon a Qualifying Equity Offering

Company XYZ issues $1 million of notes to an investor group. According to the terms of the notes, XYZ is required to pay interest semiannually at a rate of 8 percent per annum. Principal on the notes is due at maturity, which is two years after issuance. Upon a qualifying equity offering (one in which XYZ raises at least $10 million of equity), the notes are automatically converted into shares sold in the qualifying equity offering. The conversion price equals 80 percent of the price per share of the qualifying equity offering. For example, if XYZ issued $10 million of Series D preferred stock at $10 per share, the notes would be converted into Series D preferred stock at $8 per share.

The automatic conversion upon a qualifying equity offering is economically a contingent redemption of the notes for $1.25 million. However, the investors do not receive $1.25 million in cash; rather, the redemption feature is settled in shares of XYZ with a value of $1.25 million.

The redemption feature would not be considered clearly and closely related to the debt host because it is a contingent redemption and involves a significant premium relative to the amount paid by the investors — $1.25 million compared with $1 million (see ASC 815-15-25-40). Assuming that the debt is not remeasured at fair value with changes in fair value recognized in earnings, XYZ would be required to bifurcate the redemption option because a separate instrument with the same terms would be subject to derivative accounting under ASC 815.

In the evaluation of the net settlement condition under ASC 815-10-15-107(b), the assets being delivered to the holder of the debt instrument are shares of the issuer, which are not associated with any underlying because the value of the shares to be delivered is a fixed dollar amount. In other words, even though the shares are related to the event that triggers redemption (i.e., the shares delivered are the same shares issued in the qualifying equity offering) and an event is considered an underlying, the holder is indifferent to changes in value of any of the equity shares of the issuer in the time between the issuance of the debt and the triggering of the redemption feature because the holder will receive a fixed dollar amount once the redemption is triggered. Therefore, with respect to the condition in ASC 815-10-15-107(b), the shares are not associated with any underlying, regardless of whether the underlying shares are readily convertible to cash. Thus, the net settlement condition is met and the embedded redemption feature related to the automatic conversion upon a qualifying equity offering must be bifurcated from the host contract and accounted for as a derivative liability.

8.4.5 Term Extension Features

8.4.5.1 Background

Term extension features embedded in a debt host contract include those that give either party the right to extend the debt’s remaining term or automatically extend the term upon the occurrence of a specified event.

8.4.5.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a term extension feature embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	It depends	A term extension feature is not clearly and closely related to a debt host unless the interest rate is concurrently reset to a current market rate and the debt initially did not involve a significant discount (see Section 8.4.5.3).
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	It depends	The evaluation of whether a term extension feature meets the definition of a derivative depends on whether it meets the net settlement characteristic in the definition of a derivative (see Section 8.4.5.4).
Meets a scope exception (see Section 8.3.5)	Generally, yes	A term extension feature embedded in a debt host contract often qualifies for the loan commitment scope exception (see Section 8.4.5.5). However, this scope exception is not available if the term extension option is held by the creditor.

As shown in the table above, a term extension feature in a debt host would not be bifurcated if (1) the feature is considered clearly and closely related to the debt host contract (see the next section), (2) the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3), (3) the feature does not meet the definition of a derivative (see Section 8.4.5.4), or (4) the feature meets the scope exception for loan commitments (see Section 8.4.5.5).

8.4.5.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-44 An embedded derivative that either (a) unilaterally enables one party to extend significantly the remaining term to maturity or (b) automatically extends significantly the remaining term triggered by specific events or conditions is not clearly and closely related to the interest rate on a debt instrument unless the interest rate is concurrently reset to the approximate current market rate for the extended term and the debt instrument initially involved no significant discount. Thus, if there is no reset of interest rates, the embedded derivative is not clearly and closely related to the host contract. That is, a term-extending option cannot be used to circumvent the restriction in paragraph 815-15-25-26 regarding the investor’s not recovering substantially all of its initial recorded investment.

Under ASC 815-15-25-44, a term extension feature is clearly and closely related to a debt host only if (1) the interest rate is adjusted to the approximate current market rate of interest for the extended term at the time the term is extended and (2) the debt did not initially involve a significant discount.

Example 8-15

Debt With Extension Option

Company XYZ issues five-year, variable-rate debt that pays three-month LIBOR plus 250 basis points on a quarterly basis. At the end of five years, XYZ has an option to extend the debt for another three years and, if the option is exercised, XYZ will continue to pay three-month LIBOR plus 250 basis points for the extended term.

Although the debt continues to vary on the basis of three-month LIBOR if the term of the debt is extended, the interest rate does not reset to current market rates because the credit spread is not adjusted. At the end of the original five-year term, the current market rate for an issuer with the creditworthiness of XYZ may be different than three-month LIBOR plus 250 basis points (e.g., the current market rate for XYZ debt could be LIBOR plus 750 basis points), even if the creditworthiness of XYZ has not changed. Therefore, because XYZ has the option to extend the maturity of the debt significantly and the interest rate in its entirety does not reset to market, the term-extending option is not clearly and closely related to the debt host.

Note that the analysis of whether a term extension feature is clearly and closely related to a debt host is different from the analysis of whether an embedded prepayment (or call) option is clearly and closely related to a debt host (see Section 8.4.4) even though economically such features may be similar.

Example 8-16

Bonds With Extension Options

Entity ABC issues two series of bonds that are publicly traded. One bond has a five-year term and a 6 percent fixed coupon rate and grants the bondholder an option to extend the debt for another three years at a 6 percent fixed interest rate. The second bond has an eight-year term and a 6 percent fixed coupon rate and grants the bondholder an option to put the debt back to ABC at the end of five years. Although these two bonds are economically similar, they are analyzed differently under ASC 815. The first bond is analyzed as a five-year debt host contract with an embedded term extension feature. The second bond is analyzed as an eight-year debt host contract with an embedded put option.

The term-extending option in the first bond extends the maturity of the debt significantly but does not reset the interest rate to a market rate. The term-extending option, therefore, is not clearly and closely related to the debt host and may need to be bifurcated from the host contract and accounted for separately if it meets the other criteria in ASC 815-15-25-1. The embedded put option in the second bond would not be evaluated under the guidance on term extension options. Instead, it would be evaluated under the guidance on embedded put options (see Section 8.4.4).

8.4.5.4 Derivative Analysis

The table below presents an analysis of whether a term extension feature embedded in a debt host contract meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	A term extension feature in a debt host contract has both an underlying (interest rates and, if applicable, the occurrence or nonoccurrence of any exercise contingency) and a notional amount (the principal amount subject to extension) or payment provision.
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the term extension feature on a stand-alone basis without the debt host contract). Generally, a term extension feature has an initial net investment that is smaller than would be required for a direct investment in the amount of debt that is subject to the term extension (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	It depends	Typically, the debtor would evaluate whether the debt contract that will be extended is readily convertible to cash (see below).

Generally, the analysis of whether an embedded term extension feature meets the definition of a derivative focuses on whether the feature meets the net settlement characteristic. If a term extension feature does not contain an explicit net settlement provision or a market mechanism to facilitate net settlement (both of which would be uncommon), the evaluation depends on whether the instrument whose maturity is being extended is readily convertible to cash (e.g., publicly traded debt that may be sold in increments that can be rapidly absorbed by the market without significantly affecting the price). If the underlying debt is not readily convertible to cash, the embedded term extension feature should not be bifurcated as a derivative because it does not permit net settlement and therefore does not meet the definition of a derivative.

8.4.5.5 Scope Exception for Loan Commitments

Because a term extension feature is a legally binding commitment to extend the term of the debt on the basis of prespecified terms and conditions, it is economically equivalent to a loan commitment for the term extension period. Therefore, the loan commitment scope exception in ASC 815-10-15-69 through 15-71 (see Section 8.4.6.5) can be applied to a term extension feature that gives the debtor the unilateral option to extend the maturity of nonconvertible debt.

In a typical loan commitment, a potential creditor agrees to the terms under which a potential debtor may borrow money. However, the potential debtor is not legally obligated to borrow money under those terms or even from that creditor. Therefore, if the creditor has the option to extend the maturity of the debt, the instrument is not the equivalent of a loan commitment and thus would not qualify for the exception.

8.4.6 Embedded Loan Commitments (Including PIK Interest Features)

8.4.6.1 Background

A credit facility or tranche debt financing might include both an initial term loan and commitments to obtain additional term loans on specified dates in the future. Further, some debt instruments contain a PIK interest feature, which requires or permits the debtor to pay interest in the form of additional debt that has the same terms as the original debt instrument. In substance, a PIK interest feature is a loan commitment since it permits or requires the debtor to issue additional debt on specified terms to settle future interest payments.

Note that the discussion in this section only applies if the debtor has determined that the debt and the loan commitments represent one combined unit of account (see Section 3.3). If the loan commitments represent separate units of account (e.g., the commitments are legally detachable and separately exercisable from the debt), the loan commitments should not be evaluated as features embedded in the debt but as freestanding loan commitments (see Section 2.3.3).

8.4.6.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a loan commitment embedded in a debt host contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	It depends	A loan commitment whose features are not clearly and closely related to a debt instrument would not be clearly and closely related to the debt host contract (see Section 8.4.6.3).
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	It depends	The evaluation of whether a loan commitment meets the definition of a derivative depends on whether it meets the net settlement characteristic in the definition of a derivative (see Section 8.4.6.4).
Meets a scope exception (see Section 8.3.5)	It depends	The debtor should evaluate whether the commitment qualifies for the loan commitment scope exception (see Section 8.4.6.5). This scope exception is not available if the commitment is held by the potential creditor or investor.

8.4.6.3 Clearly-and-Closely-Related Analysis

A loan commitment is not clearly and closely related to a debt host contract if it includes features that are not clearly and closely related to a debt instrument. For example, a commitment to issue both debt and warrants on the debtor’s equity shares or a commitment to issue debt that is convertible into the debtor’s equity shares would not be clearly and closely related to a debt host contract since the debtor’s stock price is not clearly and closely related to a debt host.

8.4.6.4 Derivative Analysis

The table below presents an analysis of whether a loan commitment embedded in a debt host contract meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	A loan commitment embedded in a debt host contract has both an underlying (interest rates and, if applicable, the occurrence or nonoccurrence of any exercise contingency and other underlyings) and a notional amount (the committed amount of debt) or payment provision.
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the loan commitment on a stand-alone basis without the debt host contract). Generally, an embedded loan commitment feature has an initial net investment that is smaller than the committed amount of debt.
Net settlement (see Section 8.3.4.4)	It depends	The debtor should evaluate whether the debt that would be funded upon settlement of the loan commitment is readily convertible to cash (see below).

Generally, an analysis of whether an embedded loan commitment meets the definition of a derivative focuses on whether it meets the net settlement characteristic in the definition of a derivative (see Section 8.3.4.4). If the loan commitment does not contain an explicit net settlement provision or a market mechanism to facilitate net settlement (both of which would be uncommon), the evaluation of whether the feature meets the net settlement characteristic depends on whether the debt that would be funded is readily convertible to cash (e.g., publicly traded debt that may be sold in increments that can be rapidly absorbed by the market without significantly affecting the price). If the underlying debt is not readily convertible to cash, the embedded loan commitment should not be bifurcated as a derivative because it does not permit net settlement and therefore does not meet the definition of a derivative.

8.4.6.5 Scope Exception for Loan Commitments

ASC 815-10-15-69 through 15-71 contain a scope exception related to the derivative accounting requirements in ASC 815 for “a commitment to originate a loan” for the holder of the commitment (i.e., the potential borrower; see Section 2.3.3). This scope exception applies irrespective of whether (1) the commitment is contingent and (2) the loan is revolving or nonrevolving. Commitments to issue debt securities (e.g., tranche debt issuances) also qualify for this scope exception. ASC 310-10-20 defines a loan as a “contractual right to receive money on demand or on fixed or determinable dates that is recognized as an asset in the creditor’s statement of financial position. Examples include but are not limited to accounts receivable (with terms exceeding one year) and notes receivable.” We informally discussed with members of the SEC staff the application of this scope exception to commitments to issue debt securities. The staff concurred that it is appropriate to apply the loan commitment exception to an entity’s commitment to receive funds in exchange for the initial issuance of a debt security that will be an obligation of the entity.

In a typical loan commitment, the potential creditor writes an option to the potential debtor that permits the potential debtor to obtain debt on prespecified terms at its request. Therefore, the loan commitment scope exception does not apply to an option written by the potential debtor to the potential creditor under which the potential creditor could force the potential debtor to enter into a loan but does not give the potential debtor a right to elect to borrow money from the potential creditor.

ASC 815 does not clearly address whether the scope exception for loan commitments is available if the loan to be funded contains an embedded feature that will need to be bifurcated as a derivative once the loan is funded. It may therefore be prudent for an entity to further evaluate whether the loan commitment meets the definition of a derivative in ASC 815. If the loan commitment does not meet the net settlement characteristic in the definition of a derivative (e.g., it requires delivery of an underlying loan that is not readily convertible to cash and the commitment cannot otherwise be net settled), the debtor may conclude the loan commitment should not be accounted for as a derivative even if the scope exception for loan commitments is considered inapplicable.

8.4.7 Equity Features (Including Conversion, Exchange, and Indexed Features)

8.4.7.1 Background

This section discusses the analysis of whether equity features, including features that involve conversion of debt into the debtor’s equity shares or third-party stock as well as payment features indexed to a stock price or stock price index, should be separated from a debt host contract and accounted for as derivatives under ASC 815-15.

8.4.7.2 Bifurcation Analysis

8.4.7.2.1 General

The bifurcation analysis differs depending on whether the equity feature economically is an equity conversion feature settleable in the debtor’s equity shares (see the next section), an exchange feature settleable in the equity shares of a third party (see Section 8.4.7.2.3), or a payment feature indexed to a stock price or stock price index (see Section 8.4.7.2.4). The analysis of a feature that economically represents a share-settled redemption or indexation feature whose monetary value does not vary on the basis of a stock price is discussed separately (see Section 8.4.7.2.5). Such features do not represent conversion or exchange options since their monetary value is not indexed to the fair value of the shares delivered upon settlement.

8.4.7.2.2 Equity Conversion Feature

Debt instruments often contain features that require or permit the debt to be converted into the debtor’s equity shares. The table below presents an overview of the bifurcation analysis of equity conversion features embedded in a debt host contract that are settleable in the debtor’s equity shares, including the shares of a substantive consolidated entity. The table does not apply to an embedded feature that economically represents a share-settled redemption or indexation feature whose monetary value does not vary on the basis of the debtor’s stock price (see Section 8.4.7.2.5). Further, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	Yes	A change in the debtor’s stock price is not clearly and closely related to a debt host (see Section 8.4.7.3.1).
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	It depends	The debtor should evaluate whether the equity conversion feature meets the net settlement characteristic in the definition of a derivative (see Sections 8.4.7.4 and 8.4.7.5).
Meets a scope exception (see Section 8.3.5)	It depends	The issuer should evaluate whether the equity conversion feature meets the scope exception for certain contracts on own equity (see Section 8.4.7.6) or share-based payment transactions (see Section 8.4.7.7).

As shown in the table above, the analysis of whether an equity conversion feature should be bifurcated from a debt host contract under ASC 815-15 usually centers on whether the feature meets (1) the net settlement characteristic in the definition of a derivative (see Sections 8.4.7.4 and 8.4.7.5) and, if so, (2) the scope exception in ASC 815-10-15-74(a) for certain contracts issued by the reporting entity that are both indexed to its own stock and classified in stockholders’ equity in its statement of financial position (see Section 8.4.7.6).

A conversion feature might begin or cease to meet the bifurcation criteria under ASC 815-15 after the initial recognition of the instrument in which it is embedded. For instance, the assessment of whether a feature meets the scope exception for own equity may change if the entity authorizes the issuance of additional shares (see Section 5.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). The accounting analysis might also change if a conversion feature becomes readily convertible to cash because a market develops for the underlying shares (see Section 8.4.7.5.6). The issuer must monitor such changes on an ongoing basis.

ASC 815-15

Case U: Convertible Debt Instrument

55-217 In a convertible debt instrument, an investor receives a below-market interest rate and receives the option to convert its debt instrument into the equity of the issuer at an established conversion rate. The terms of the conversion require that the issuer deliver shares of stock to the investor.

55-218 This instrument essentially contains a call option on the issuer’s stock. Under the provisions of this Subtopic, the accounting by the issuer and investor can differ. The issuer’s accounting depends on whether a separate instrument with the same terms as the embedded written option would be a derivative instrument pursuant to Section 815-10-15. Assuming the option is indexed to the issuer’s own stock and a separate instrument with the same terms would be classified in stockholders’ equity in the statement of financial position, the written option is not considered to be a derivative instrument for the issuer under paragraph 815-10-15-74(a) and should not be separated from the host contract.

55-219 In contrast, if the terms of the conversion allow for a cash settlement rather than delivery of the issuer’s shares at the investor’s option, the exception in paragraph 815-10-15-74(a) for the issuer does not apply because the contract would not be classified in stockholders’ equity in the issuer’s statement of financial position. In that circumstance, the issuer should separate the embedded derivative from the host contract and account for it pursuant to the provisions of this Subtopic because both of the following conditions exist:

An option based on the entity’s stock price is not clearly and closely related to an interest-bearing debt instrument.
The option would not be considered an equity instrument of the issuer (see paragraph 815-40-25-4(a)(2)).

55-220 Similarly, if the convertible debt is indexed to another entity’s publicly traded common stock, the issuer should separate the embedded derivative from the host contract and account for it pursuant to the provisions of this Subtopic because both of the following conditions exist:

An option based on another entity’s stock price is not clearly and closely related to an investment in an interest-bearing note.
The option would not be considered an equity instrument of the issuer.

55-221 The exception in paragraph 815-10-15-74 does not apply to the investor’s accounting. Therefore, in both circumstances described, the investor should separate the embedded option contract from the host contract and account for the embedded option contract pursuant to the provisions of this Subtopic because the option contract is based on the price of another entity’s equity instrument and thus is not clearly and closely related to an investment in an interest-bearing note. However, if the terms of conversion do not allow for a cash settlement and if the common stock delivered upon conversion is privately held (that is, is not readily convertible to cash), the embedded derivative would not be separated from the host contract because it would not meet the criteria for net settlement as discussed beginning in paragraph 815-10-15-99.

The description of the accounting for an equity conversion feature in a debt host in ASC 815-15-55-217 through 55-221 contains certain unstated, simplified assumptions that are not always applicable. Therefore, an entity cannot rely solely on those paragraphs in its accounting analysis for an equity conversion feature and must also consider other guidance in ASC 815. In particular, it is assumed in ASC 815-15-55-218 that the debtor can apply the scope exception in ASC 815-10-15-74(a) to the conversion feature, but this is not always an appropriate assumption (see Section 8.4.7.6). Further, it is assumed in ASC 815-15-55-219 that the hybrid instrument is not accounted for at fair value, with changes in fair value recognized in net income. However, if the hybrid instrument is accounted for at fair value, with changes in fair value recognized in earnings, bifurcation would not be appropriate (see Section 8.3.3).

8.4.7.2.3 Exchange Feature Involving Third-Party Stock

ASC 470-20 — SEC Materials — SEC Staff Guidance

Comments Made by SEC Observer at Emerging Issues Task Force (EITF) Meetings

SEC Observer Comment: Debt Exchangeable for the Stock of Another Entity

S99-1 The following is the text of the SEC Observer Comment: Debt Exchangeable for the Stock of Another Entity.

An issue has been discussed involving an enterprise that holds investments in common stock of other enterprises and issues debt securities that permit the holder to acquire a fixed number of shares of such common stock. These types of transactions are commonly affected through the sale of either debt with detachable warrants that can be exchanged for the stock investment or debt without detachable warrants (the debt itself must be exchanged for the stock investment — also referred to as “exchangeable” debt). Those debt issues differ from traditional warrants or convertible instruments because the traditional instruments involve exchanges for the equity securities of the issuer. There have been questions as to whether the exchangeable debt should be treated similar to traditional convertibles as specified in Subtopic 470-20 or whether the transaction requires separate accounting for the exchangeability feature. The SEC staff believes that Subtopic 470-20 does not apply to the accounting for debt that is exchangeable for the stock of another entity and therefore separation of the debt element and exchangeability feature is required.

A debt instrument may contain a feature that requires or permits its exchange into the shares of a third party. For example, a debt instrument may give the holder the option to require that the issuer deliver a fixed number of shares of a third party’s common stock in lieu of repaying the debt’s principal amount at maturity. Although from the holder’s perspective, the economic characteristics and risks of an investment in such a debt instrument are similar to those of an investment in convertible debt, the issuer should not analyze the exchange feature as an equity conversion feature that potentially could qualify for the scope exception for certain contracts on own equity since it is not settled in the debtor’s equity shares.

In consolidated financial statements, a debt instrument issued by a parent entity or its subsidiary that is exchangeable into the subsidiary’s equity shares is analyzed in a manner similar to a contract that is convertible into the parent’s equity shares, provided that the subsidiary is a substantive entity (see Section 2.6.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). This is true irrespective of whether the instrument is issued by the parent or subsidiary. Therefore, the exchange feature would be analyzed as an equity conversion feature involving the company’s own stock under ASC 815-15 (see Section 8.4.7.2.2).

In the subsidiary’s separate financial statements, the parent’s equity is not considered equity of the subsidiary. Therefore, a debt instrument that is issued by a subsidiary and exchangeable into the parent’s equity shares would not be analyzed as an instrument that is convertible into the issuer’s equity shares in the subsidiary’s separate financial statements (see Section 2.6.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). In the parent’s consolidated financial statements, however, the same instrument would be analyzed as a debt instrument that is convertible into the issuer’s equity shares, as discussed above.

Equity shares issued by an equity method investee are not considered part of the entity’s own equity. Therefore, debt instruments that are exchangeable into the shares of an equity method investee are analyzed as an exchange feature that is settleable in third-party stock under ASC 815-15.

The table below presents an overview of the bifurcation analysis of a feature that requires or permits a debt contract to be exchanged for shares of stock issued by a third party (other than shares of stock issued by a substantive consolidated entity). The table does not apply to a feature that economically represents a share-settled redemption or indexation feature whose monetary value does not vary on the basis of the third party’s stock price (see Section 8.4.7.2.5). An entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	Yes	The changes in the fair value of an equity interest are not clearly and closely related to a debt host (see Section 8.4.7.3.2).
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	It depends	The debtor should evaluate whether the feature meets the net settlement characteristic in the definition of a derivative (see Sections 8.4.7.4 and 8.4.7.5).
Meets a scope exception (see Section 8.3.5)	No	There is no specific scope exception available for features that involve the exchange of debt for shares issued by a third party (other than shares of stock issued by a substantive consolidated entity).

As shown in the table above, a debtor’s determination of whether an exchange feature settleable in third-party stock must be bifurcated as a derivative tends to focus on whether the feature meets the net settlement characteristic in the definition of a derivative (see Sections 8.4.7.4 and 8.4.7.5) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3). Such features are not clearly and closely related to a debt host contract (see Section 8.4.7.3.2) and are not exempt from the scope of derivative accounting.

8.4.7.2.4 Equity-Indexed Payment Features

The table below presents an overview of the bifurcation analysis of an equity-indexed payment feature embedded in a debt host contract (e.g., a debt contract with principal or interest payments indexed to the S&P 500 Index). An entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	Yes	The changes in the fair value of an equity interest are not clearly and closely related to a debt host (see Section 8.4.7.3.2).
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	Yes	An equity-indexed payment feature meets the definition of a derivative (see Section 8.4.7.4.2).
Meets a scope exception (see Section 8.3.5)	No	There is no specific scope exception available for an equity-indexed payment feature embedded in a debt host.

As shown in the table above, an equity-indexed payment feature typically must be bifurcated as a derivative unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).

8.4.7.2.5 Share-Settled Redemption Features

A financial instrument may contain a term that is described as an equity conversion or exchange feature but economically represents a share-settled redemption or indexation provision whose monetary value does not vary on the basis of a stock price or stock price index. The number of equity shares is variable and is calculated to be equal in value to a fixed or specified monetary amount (e.g., the principal amount plus accrued and unpaid interest) or a monetary amount that is indexed to an unrelated underlying (e.g., the price of gold).

Even if the terms of the instrument refer to the share-settled feature as an equity conversion or exchange feature, the issuer should not analyze it as such since it does not have the economic payoff profile of an equity conversion or exchange feature. Instead, the issuer should (1) evaluate the feature as a put, call, redemption, or other indexed feature, as applicable, and (2) determine whether the feature must be separated as a derivative instrument under ASC 815-15. (If the instrument is issued in the form of an equity share [e.g., preferred stock], the issuer should also evaluate whether the feature results in the requirement to classify the instrument as a liability under ASC 480; see Chapter 6 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.)

Example 8-17

Debt Settleable for Variable Number of Shares Upon a Qualified Equity Financing

A debt instrument includes a feature that must be “converted” into the debtor’s common stock upon a qualified equity financing. The conversion price is defined as (1) the outstanding amount of principal and interest divided by (2) the price of a share of common stock in the qualified equity offering. Although the contract refers to the feature as a conversion feature and it must be settled in shares of common stock, the instrument should not be analyzed as a debt instrument with an equity conversion feature because the monetary value of the shares delivered upon conversion is unrelated to the fair value of the issuer’s equity shares. Instead, under ASC 815-15, this feature should be evaluated as a contingent redemption option; it would not be evaluated as a conversion feature even though it is settled in the debtor’s equity shares (see Section 8.4.4).

Example 8-18

Debt Indexed to S&P 500 Index

A debt instrument with a principal amount of $1 million contains a “conversion” feature that requires the issuer to settle, at the holder’s option, the instrument in a variable number of common shares equal in value to $1 million adjusted for changes in the S&P 500 Index. Under ASC 815-15, this feature would not be analyzed as an equity conversion feature. Instead, it should be evaluated as a payment feature indexed to the S&P 500 Index (see Section 8.4.7.2.4).

A share-settled redemption or indexation feature meets the net settlement characteristic in the definition of a derivative irrespective of whether the shares that will be delivered upon settlement are readily convertible to cash. Because the monetary amount of the obligation does not depend on the share price, neither party is required to deliver an asset (1) that is associated with the underlying and (2) whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the notional amount (see Section 8.4.4.4.2). In the evaluation of whether the net settlement criterion in ASC 815-10-15-107(b) has been met, the assets being delivered to the holder upon the feature’s settlement are treated as shares of the issuer. Such shares are not associated with the embedded feature’s underlying because the monetary value of the shares to be delivered does not vary on the basis of the share price. In other words, the holder is indifferent to changes in value of any of the equity shares until the feature is settled. Therefore, the net settlement criterion is met regardless of whether the underlying shares are readily convertible to cash.

8.4.7.3 Clearly-and-Closely-Related Analysis

8.4.7.3.1 Equity Conversion or Exchange Features

ASC 815-15

25-51 The changes in fair value of an equity interest and the interest rates on a debt instrument are not clearly and closely related. Thus, for a debt security that is convertible into a specified number of shares of the debtor’s common stock or another entity’s common stock, the embedded derivative (that is, the conversion option) shall be separated from the debt host contract and accounted for as a derivative instrument provided that the conversion option would, as a freestanding instrument, be a derivative instrument subject to the requirements of this Subtopic. (For example, if the common stock was not readily convertible to cash, a conversion option that requires purchase of the common stock would not be accounted for as a derivative instrument.) That accounting applies only to the holder (investor) if the debt is convertible to the debtor’s common stock because, under paragraph 815-10-15-74(a), a separate option with the same terms would not be a derivative instrument for the issuer.

A conversion or exchange feature whose value varies on the basis of changes in the equity instruments that would be issued upon conversion is not clearly and closely related to a debt host because the economic characteristics and risks of an equity instrument differs from the economic characteristics and risks of a debt instrument. Such a feature is not clearly and closely related to a debt host irrespective of whether it is considered indexed to the entity’s own equity under ASC 815-40 (see Section 8.4.7.6).

The accounting for an equity conversion feature in a debt host in ASC 815-15-25-51 is premised on certain unstated, simplified assumptions that are not always applicable. Therefore, an entity cannot rely solely on that paragraph in its accounting analysis for an equity conversion feature and must also consider other guidance in ASC 815. For example, it is assumed in the second sentence in ASC 815-15-25-51 that the hybrid instrument is not accounted for at fair value, with changes in fair value recognized in net income. However, if the hybrid instrument is accounted for at fair value, with changes in fair value recognized in earnings, bifurcation would not be required (see Section 8.3.3). Further, it is assumed in the final sentence in ASC 815-15-25-51 that the equity conversion feature meets the scope exception in ASC 815-10-15-74(a), which is not always an appropriate assumption (see Section 8.4.7.6).

8.4.7.3.2 Equity-Indexed Payment Feature

ASC 815-15

25-49 The changes in fair value of an equity interest and the interest yield on a debt instrument are not clearly and closely related. Thus, an equity-related derivative instrument embedded in an equity-indexed debt instrument (whether based on the price of a specific common stock or on an index that is based on a basket of equity instruments) shall be separated from the host contract and accounted for as a derivative instrument.

Example 7: Clearly and Closely Related Criterion — Characterizing a Debt Host

55-117 This Example illustrates the application of the clearly and closely related criterion in paragraph 815-15-25-1(a) to the determination of what is the host contract and what is the embedded derivative composing the illustrative hybrid instrument. This Example has the following assumptions:

An entity (Entity A) issues a 5-year debt instrument with a principal amount of $1,000,000 indexed to the stock of an unrelated publicly traded entity (Entity B).
At maturity, the holder of the instrument will receive the principal amount plus any appreciation or minus any depreciation in the fair value of 10,000 shares of Entity B, with changes in fair value measured from the issuance date of the debt instrument.
No separate interest payments are made.
The market price of Entity B shares to which the debt instrument is indexed is $100 per share at the issuance date.

55-118 The instrument is not itself a derivative instrument because it requires an initial net investment equal to the notional amount. The host contract is a debt instrument because the instrument has a stated maturity and because the holder has none of the rights of a shareholder, such as the ability to vote the shares and receive distributions to shareholders. The embedded derivative is an equity-based derivative that has as its underlying the fair value of the stock of Entity B. As a result of the host instrument being a debt instrument and the embedded derivative having an equity-based return, the embedded derivative is not clearly and closely related to the host contract and must be separated from the host contract and accounted for as a derivative by both the issuer and the holder of the hybrid instrument. (Paragraph 815-15-25-4 allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Topic 815 hedging relationship.)

Example 8: Clearly and Closely Related Criterion — Debt Instrument Incorporating Equity-Based Return

55-119 This Example illustrates the application of the clearly and closely related criterion in paragraph 815-15-25-1(a). Even though an overall hybrid instrument that provides for repayment of principal may include a return based on the market price (the underlying as defined) of XYZ Corporation common stock, the host contract does not involve any existing or potential residual interest rights (that is, rights of ownership) and thus would not be an equity instrument. The host contract would instead be considered a debt instrument, and the embedded derivative that incorporates the equity-based return would not be clearly and closely related to the host contract.

Case H: Equity-Indexed Note

55-189 An equity-indexed note is a bond for which the return of interest, principal, or both is tied to a specified equity security or index, for instance, the Standard and Poor’s 500 S&P 500 Index. This instrument may contain a fixed or varying coupon rate and may place all or a portion of principal at risk.

55-190 An equity-indexed note essentially combines an interest-bearing instrument with a series of forward exchange contracts or option contracts. Often, a portion of the coupon interest rate is, in effect, used to purchase options that provide some form of floor on the potential loss of principal that would result from a decline in the referenced equity index. Because forward or option contracts for which the underlying is an equity index are not clearly and closely related to an investment in an interest-bearing note, those embedded derivatives should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

Case I: Variable Principal Redemption Bond

55-191 A variable principal redemption bond’s principal redemption value at maturity depends on the change in an underlying index over a predetermined observation period. A typical circumstance would be a bond that guarantees a minimum par redemption value of 100 percent and provides the potential for a supplemental principal payment at maturity as compensation for the below-market rate of interest offered with the instrument.

55-192 Assume that a supplemental principal payment will be paid to the investor, at maturity, if the final S&P 500 closing value (determined at a specified date) is less than its initial value at date of issuance and the 10-year U.S. Treasury constant maturities is greater than 2 percent as of a specified date. In all circumstances, the minimum principal redemption will be 100 percent of par.

55-193 A variable principal redemption bond essentially combines an interest-bearing investment with an option that is purchased with a portion of the bond’s coupon interest payments. Because the embedded option entitling the investor to an additional return is partially contingent on the S&P 500 index closing above a specified amount, it is not clearly and closely related to an investment in a debt instrument. Therefore, the embedded option should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

Case P: Specific Equity-Linked Bond

55-207 A specific equity-linked bond pays a coupon slightly below that of traditional bonds of similar maturity; however, the principal amount is linked to the stock market performance of an equity investee of the issuer. The issuer may settle the obligation by delivering the shares of the equity investee or may deliver the equivalent fair value in cash.

55-208 A specific equity-linked bond can be viewed as combining an interest-bearing instrument with, depending on its terms, a series of forward exchange contracts or option contracts based on an equity instrument. Often, a portion of the coupon interest rate is used to purchase options that provide some form of floor on the loss of principal due to a decline in the price of the referenced equity instrument. The forward or option contracts do not qualify for the exception in paragraph 815-10-15-59(b) because the shares in the equity investee owned by the issuer meet the definition of a financial instrument. Because forward or option contracts for which the underlying is the price of a specific equity instrument are not clearly and closely related to an investment in an interest-bearing note, the embedded derivative should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

In a manner similar to an equity conversion or exchange feature (see Section 8.4.7.3.1), a feature that adjusts the contractual payments on the basis of a stock price or stock price index is not clearly and closely related to a debt host. Accordingly, a contractual provision in a debt host that involve payments that are indexed to a stock price or stock price index must be bifurcated as a derivative if the other bifurcation conditions in ASC 815-15-25-1 are also met.

Example 8-19

Debt With Principal Amount That Is Indexed to Stock Price

Company ABC issues $100 million of five-year debt. The debt pays an annual coupon of 6 percent and is indexed to the price of 1 million shares of Company XYZ’s common stock. Company XYZ is listed on the New York Stock Exchange and, on the date on which the debt is issued, its stock price is $100 per share. At debt maturity, if XYZ’s common stock has appreciated in value to $200 per share, ABC will pay $200 million; however, if the value of XYZ’s stock has depreciated to $50 per share at maturity, ABC will pay $50 million.

Although the return on the debt is linked to an equity instrument (XYZ’s stock), the host contract is considered a debt host because the instrument is legal form debt with a stated maturity and no shareholder rights. The embedded equity forward is not clearly and closely related to the debt host; therefore, the embedded derivative must be bifurcated and accounted for at fair value unless the issuer elects to measure the entire hybrid financial instrument at fair value, with changes in fair value recognized in earnings.

If ABC was required to deliver XYZ’s shares to the investor instead of adjusting the amount of cash paid at maturity of the debt, ABC would need to assess whether XYZ’s shares are readily convertible to cash (i.e., whether the 1 million shares significantly affect the market price of XYZ) to determine whether the embedded equity forward meets the definition of a derivative instrument. See the next section (and Section 8.4.7.5) for more information.

8.4.7.4 Derivative Analysis

8.4.7.4.1 Equity Conversion or Exchange Feature

The table below presents an analysis of whether an equity conversion or exchange feature meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	An equity conversion or exchange feature has both an underlying (the fair value of the equity instruments that would be issued upon conversion and, if applicable, the occurrence or nonoccurrence of any exercise contingency) and a notional amount (the number of shares that would be issued upon conversion).
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the equity conversion feature on a stand-alone basis without the host contract). Generally, an equity conversion or exchange feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the stock price (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	It depends	The net settlement characteristic is met if either (1) the equity conversion or exchange feature can be explicitly net settled (e.g., its fair value can be settled net in shares or net in cash) or (2) the shares that would be issued upon conversion are readily convertible to cash. The net settlement characteristic is not met if the equity conversion or exchange feature must be gross physically settled and the shares that would be delivered upon conversion are not readily convertible to cash. For a detailed discussion of the net settlement analysis, see Section 8.4.7.5.

Generally, an analysis of whether an equity conversion or exchange feature meets the definition of a derivative focuses on whether it meets the net settlement characteristic (see Section 8.4.7.5).

8.4.7.4.2 Equity-Indexed Payment Feature

The table below presents an analysis of whether an equity-indexed payment feature meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	An equity-indexed payment feature has both an underlying (a stock price or stock price index) and a notional amount (the debt’s principal amount) or payment provision.
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the equity-indexed payment feature on a stand-alone basis without the host contract). Generally, an equity-indexed payment feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the stock price or stock price index (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	Yes	A feature that adjusts the payments of a debt host contract on the basis of a stock price or stock price index meets the net settlement condition since 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 feature’s notional amount. (If the feature must be settled by delivery of the underlying shares of stock, however, the considerations in Section 8.4.7.5 apply.)

As shown in the table above, an equity-indexed payment feature embedded in a debt host contract typically meets the definition of a derivative. Because such a feature is not clearly and closely related to a debt host and does not qualify for any scope exception, it must be bifurcated as a derivative unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).

8.4.7.5 Net Settlement Analysis

8.4.7.5.1 Background

An equity conversion or exchange feature (see Sections 8.4.7.2.2 and 8.4.7.2.3) embedded in a debt host contract does not meet the definition of a derivative instrument on a stand-alone basis unless it satisfies the net settlement characteristic in that definition. In evaluating whether an embedded conversion or exchange feature can be explicitly net settled, the entity should consider all of the debt instrument’s terms (e.g., redemption and liquidation features). Different considerations apply in the following situations:

The feature must or may be settled in cash (see Section 8.4.7.5.2).
The feature must or may be settled net in shares (see Section 8.4.7.5.3).
The feature requires physical settlement in stock that is not restricted (see Section 8.4.7.5.4).
The feature requires physical settlement in restricted stock (see Section 8.4.7.5.5).

These considerations do not apply to an equity-indexed payment feature that adjusts the payments of a debt host contract on the basis of a stock price or stock price index unless it is settled by delivery of the feature’s underlying shares of stock. Such a feature meets the net settlement characteristic irrespective of whether it is settled in cash or other assets (including those that are not readily convertible to cash) since neither party is required to deliver an asset whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the feature’s notional amount (see Section 8.4.7.4.2).

8.4.7.5.2 Features That Must or May Be Settled in Cash Upon Settlement

A conversion or exchange feature that must be net cash settled or can be settled in cash at either party’s election meets the net settlement characteristic. Convertible debt instruments often specify that, upon conversion, the issuer or the investor may elect to have the instrument settle in an amount of cash that is equal to the value of the shares that would be received upon conversion (in exchange for the convertible instrument) instead of having shares delivered. For example, conversion features embedded in convertible instruments in the form of Instruments A, B, C, or X (see Section 2.3.2.2) meet the net settlement characteristic in the definition of a derivative irrespective of whether the underlying shares are readily convertible to cash, since such instruments either require or permit the conversion value or the conversion spread to be settled in cash.

In other cases, a conversion or exchange feature that is embedded in a debt host meets the net settlement characteristic even if, according to the feature’s stated terms, physical delivery is required of shares that are not readily convertible to cash. For example, a convertible instrument may be redeemable by the holder and, upon redemption, the holder may receive cash equal to the greater of (1) the face value plus accrued interest or (2) the value of the shares that would be received had the holder exercised the conversion option (this alternative is sometimes described as cash equal to the fair value of the convertible instrument, which is presumably equal to the combined fair value of the debt host and embedded conversion option). The conversion option, by its terms, may only be settled physically. However, the redemption feature permits net cash settlement of the conversion option; therefore, the conversion option meets the net settlement characteristic.

A conversion or exchange feature that is embedded in a debt host is considered to meet the net settlement characteristic in the definition of a derivative even if the ability to net cash settle the feature is contingent on the occurrence or nonoccurrence of an event (e.g., an IPO or a change of control). For example, the terms of a convertible debt instrument might specify that an equity conversion feature must be settled in shares, which are not readily convertible to cash. However, the terms may also specify that if an IPO were to occur, the holder may elect to have the instrument settle in an amount of cash that is equal to the fair value of the shares that would be otherwise received upon conversion instead of having shares delivered. In this scenario, the conversion feature meets the net settlement characteristic because it can be explicitly net cash settled upon an IPO.

Sometimes, a conversion or exchange feature embedded in a debt host can be effectively net cash settled through the conversion and subsequent redemption of the shares that are delivered upon conversion. If the shares that will be delivered upon the settlement of a conversion or exchange feature have redemption or liquidation terms that apply in scenarios other than an ordinary liquidation, the issuer should carefully evaluate those terms to determine whether the embedded feature can be effectively net cash settled. For example, a debt instrument may be convertible by the holder into preferred stock (which is not readily convertible to cash) upon a change of control. If the terms of the preferred stock permit the holder to redeem it for cash or other assets upon a change of control, the conversion feature meets the net settlement characteristic in the definition of a derivative. If, however, the holder is required, upon conversion, to own preferred shares that are not readily convertible to cash for a substantive period before they can be redeemed and the investor is exposed to changes in the value of the preferred shares, the net settlement characteristic is not met.

8.4.7.5.3 Net-Share-Settled Features

ASC 815-10

15-102 The net settlement criterion as described in paragraph 815-10-15-83(c) and related paragraphs in this Subsection is met if a contract provides for net share settlement at the election of either party. Therefore, if either counterparty could net share settle a contract, then it would be considered to have the net settlement characteristic of a derivative instrument regardless of whether the net shares received were readily convertible to cash as described in paragraph 815-10-15-119 or were restricted for more than 31 days as discussed beginning in paragraph 815-10-15-130. While this conclusion applies to both investors and issuers of contracts, issuers of those net share settled contracts shall consider whether such contracts qualify for the scope exception in paragraph 815-10-15-74(a). See Example 5 (paragraph 815-10-55-90).

Example 5: Net Settlement Under Contract Terms — Net Share Settlement

55-90 This Example illustrates the concept of net share settlement. Entity A has a warrant to buy 100 shares of the common stock of Entity X at $10 a share. Entity X is a privately held entity. The warrant provides Entity X with the choice of settling the contract physically (gross 100 shares) or on a net share basis. The stock price increases to $20 a share. Instead of Entity A paying $1,000 cash and taking full physical delivery of the 100 shares, the contract is net share settled and Entity A receives 50 shares of stock without having to pay any cash for them. (Net share settlement is sometimes described as a cashless exercise.) The 50 shares are computed as the warrant’s $1,000 fair value upon exercise divided by the $20 stock price per share at that date.

A conversion or exchange feature that can be settled net in shares meets the net settlement characteristic even if the shares are not readily convertible to cash. For example, a convertible debt instrument might specify that, upon conversion, the outstanding amount of principal and interest will be settled in cash, and the conversion spread in shares. In this scenario, the conversion feature is net share settled and meets the net settlement characteristic of a derivative.

8.4.7.5.4 Physically Settled Features

ASC 815-10

15-130 A security that is publicly traded but for which the market is not very active is readily convertible to cash if the number of shares or other units of the security to be exchanged is small relative to the daily transaction volume. That same security would not be readily convertible if the number of shares to be exchanged is large relative to the daily transaction volume.

A conversion or exchange feature that is embedded in a debt host and that requires physical settlement in equity shares upon settlement meets the net settlement characteristic if the shares that would be issued upon settlement are readily convertible to cash (see Section 8.3.4.4.4). If the terms of the shares that would be delivered upon conversion permit the holder to redeem them for cash upon conversion, the feature meets the net settlement characteristic even if the shares are not currently readily convertible to cash (see Section 8.4.7.5.2). An equity conversion feature that is embedded in a debt host and fails to meet any of the conditions for equity classification in ASC 815-40-25 (e.g., sufficient authorized and unissued shares; see Section 8.4.7.6.5) would typically possess the net settlement characteristic because it would be presumed that the entity would be required to net cash settle the feature.

A share of a company’s stock is considered to be readily convertible to cash if the share price is quoted in an active market that can rapidly absorb the smallest increment of shares available for exchange under the contract without any significant impact on the quoted price. Typically, shares traded in a public market are readily convertible to cash unless the smallest number of shares that can be exchanged under the contract is large relative to the daily trading volume of the shares (see below) or the costs of converting the shares into cash (e.g., sales commissions on the quoted price) are in excess of 10 percent of the stock price at the inception of the contract (see Section 8.3.4.4.4). However, shares are not considered readily convertible to cash if the sale or transfer of the issued shares is restricted for a period of 32 days or more from the date on which a conversion feature is exercised (see Section 8.4.7.5.5).

ASC 815-10

Example 7: Net Settlement — Readily Convertible to Cash — Effect of Daily Transaction Volumes

55-99 The following Cases illustrate consideration of the relevance of daily transaction volumes to the characteristic of net settlement in deciding whether, from the investor’s perspective, the convertible bond contains an embedded derivative that must be accounted for separately:

Single bond with multiple conversion options (Case A)
Multiple bonds each having single conversion option (Case B).

55-100 The Cases illustrate that the form of the financial instrument is important; paragraph 815-10-15-123 explains that individual instruments cannot be combined for evaluation purposes to circumvent compliance with the criteria beginning in paragraph 815-10-15-119. Further, paragraph 815-10-15-111(c) explains that contracts shall be evaluated on an individual basis, not on an aggregate-holdings basis.

Case A: Single Bond With Multiple Conversion Options

55-101 Investor A holds a convertible bond classified as an available-for-sale security under Topic 320. The bond has all of the following additional characteristics:

It is not exchange-traded and can be converted into common stock of the debtor, which is traded on an exchange.
It has a face amount of $100 million and is convertible into 10 million shares of common stock.
It may be converted in full or in increments of $1,000 immediately or at any time during the next 2 years.
If it were converted in a $1,000 increment, Investor A would receive 100 shares of common stock.

55-102 Assume further that the market condition for the debtor’s stock is such that up to 500,000 shares of its stock can be sold rapidly without the share price being significantly affected.

55-103 The embedded conversion option meets the criteria in paragraph 815-10-15-83(a) through (b) but does not meet the criteria in paragraphs 815-10-15-100 and 815-10-15-110, in part because the option is not traded and it cannot be separated and transferred to another party.

55-104 It is clear that the embedded equity conversion feature is not clearly and closely related to the debt host instrument.

55-105 The bond may be converted in $1,000 increments and those increments, by themselves, may be sold rapidly without significantly affecting price, in which case the criteria discussed beginning in paragraph 815-10-15-119 would be met. However, if the holder simultaneously converted the entire bond, or a significant portion of the bond, the shares received could not be readily converted to cash without incurring a significant block discount.

55-106 From Investor A’s perspective, the conversion option should be accounted for as a compound embedded derivative in its entirety, separately from the debt host, because the conversion feature allows the holder to convert the convertible bond in 100,000 increments and the shares converted in each increment are readily convertible to cash under the criteria discussed beginning in paragraph 815-10-15-119. Investor A need not determine whether the entire bond, if converted, could be sold without affecting the price.

55-107 Because the $100 million bond is convertible in increments of $1,000, the convertible bond is essentially embedded with 100,000 equity conversion options, each with a notional amount of 100 shares. Each of the equity conversion options individually has the characteristic of net settlement discussed beginning in paragraph 815-10-15-119 because the 100 shares to be delivered are readily convertible to cash. Because the equity conversion options are not clearly and closely related to the host debt instrument, they must be separately accounted for. However, because an entity cannot identify more than 1 embedded derivative that warrants separate accounting, the 100,000 equity conversion options must be bifurcated as a single compound derivative. (Paragraphs 815-15-25-7 through 25-10 say an entity is not permitted to account separately for more than one derivative feature embedded in a single hybrid instrument.)

55-108 There is a substantive difference between a $100 million convertible debt instrument that can be converted into equity shares only at one time in its entirety and a similar instrument that can be converted in increments of $1,000 of tendered debt; the analysis of the latter should not presume equality with the former.

Case B: Multiple Bonds Each Having Single Conversion Option

55-109 Investor B has 100,000 individual $1,000 bonds that each convert into 100 shares of common stock. Assume those bonds are individual instruments but they were issued concurrently to Investor B.

55-110 From Investor B’s perspective, the individual bonds each contain an embedded derivative that must be separately accounted for. Each individual bond is convertible into 100 shares, and the market would absorb 100 shares without significantly affecting the price of the stock.

As discussed in Section 8.3.4.4, 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. ASC 815-10-55-101 through 55-108 contain an illustration of a $100 million bond that is convertible into 10 million shares of stock when the market can rapidly absorb 500,000 shares without a significant effect on the share price. If the terms of that bond permit the holder to convert the bond in $1,000 increments for 100 shares each, the embedded conversion feature would be considered readily convertible to cash under ASC 815-10-55-119 even though the aggregate number of shares that would be issued if the holder converted the entire bond could not be readily converted to cash without incurring a significant block discount. If, under the above terms, the bond could only be converted at one time in its entirety, the equity conversion feature would not meet the net settlement characteristic since the stock market could not rapidly absorb 500,000 shares without a significant effect on the share price.

8.4.7.5.5 Features Physically Settled in Restricted Stock

ASC 815-10

15-131 Shares of stock in a publicly traded entity to be received upon the exercise of a stock purchase warrant do not meet the characteristic of being readily convertible to cash if both of the following conditions exist:

The stock purchase warrant is issued by an entity for only its own stock (or stock of its consolidated subsidiaries).
The sale or transfer of the issued shares is restricted (other than in connection with being pledged as collateral) for a period of 32 days or more from the date the stock purchase warrant is exercised.

15-132 Restrictions imposed by a stock purchase warrant on the sale or transfer of shares of stock that are received from the exercise of that warrant issued by an entity for other than its own stock (whether those restrictions are for more or less than 32 days) do not affect the determination of whether those shares are readily convertible to cash. The accounting for restricted stock to be received upon exercise of a stock purchase warrant shall not be analogized to any other type of contract.

15-133 Newly outstanding shares of common stock in a publicly traded company to be received upon exercise of a stock purchase warrant cannot be considered readily convertible to cash if, upon issuance of the shares, the sale or transfer of the shares is restricted (other than in connection with being pledged as collateral) for more than 31 days from the date the stock purchase warrant is exercised (not the date the warrant is issued), unless the holder has the power by contract or otherwise to cause the requirement to be met within 31 days of the date the stock purchase warrant is exercised.

15-134 In contrast, if the sale of an actively traded security is restricted for 31 days or less from the date the stock purchase warrants are exercised, that limitation is not considered sufficiently significant to serve as an impediment to considering the shares to be received upon exercise of those stock purchase warrants as readily convertible to cash.

15-135 The guidance that a restriction for more than 31 days prevents the shares from being considered readily convertible to cash applies only to stock purchase warrants issued by an entity for its own shares of stock, in which case the shares being issued upon exercise are newly outstanding (including issuance of treasury shares) and are restricted with respect to their sale or transfer for a specified period of time beginning on the date the stock purchase warrant is exercised.

15-136 However, even if the sale or transfer of the shares is restricted for 31 days or less after the stock purchase warrant is exercised, an entity still must evaluate both of the following criteria:

Whether an active market can rapidly absorb the quantity of stock to be received upon exercise of the warrant without significantly affecting the price
Whether the other estimated costs to convert the stock to cash are expected to be not significant. (The assessment of the significance of those conversion costs shall be performed only at inception of the contract.)

Thus, the guidance in paragraph 815-10-15-122 shall be applied to those stock purchase warrants with sale or transfer restrictions of 31 days or less on the shares of stock.

15-137 If the shares of an actively traded common stock to be received upon exercise of the stock purchase warrant can be reasonably expected to qualify for sale within 31 days of their receipt, such as may be the case under SEC Rule 144, Selling Restricted and Control Securities, or similar rules of the SEC, any initial sales restriction is not an impediment to considering those shares as readily convertible to cash, as that phrase is used in paragraph 815-10-15-119. (However, a restriction on the sale or transfer of shares of stock that are received from an entity other than the issuer of that stock through the exercise of another option or the settlement of a forward contract is not an impediment to considering those shares readily convertible to cash, regardless of whether the restriction is for a period that is more or less than 32 days from the date of exercise or settlement.)

The shares that would be delivered upon the settlement of a conversion feature are not considered readily convertible to cash if (1) their sale or transfer is restricted for a period of 32 days or more from the date on which the feature is exercised and (2) the holder does not have “the power by contract or otherwise to cause the requirement to be met within 31 days.” If the shares to be delivered are actively traded and can reasonably be expected to qualify for sale within 31 days, however, they may be considered readily convertible to cash even if their sale or transfer is restricted (see ASC 815-10-15-137). Note, however, that the guidance on restricted stock does not apply to exchange features that restrict the sale or transfer of third-party stock that would be delivered upon settlement of an exchange feature (see ASC 815-10-15-132).

8.4.7.5.6 Ongoing Assessment

ASC 815-10

Case B: Initial Public Offering Makes Shares Readily Convertible to Cash After Contract Inception

55-87 A nontransferable forward contract on a nonpublic entity’s stock that provides only for gross physical settlement is generally not a derivative instrument because the net settlement criteria are not met. If the entity, at some point in the future, accomplishes an initial public offering of its shares and the original contract is still outstanding, the shares to be delivered would be considered to be readily convertible to cash (assuming that the shares under the contract could be rapidly absorbed in the market without significantly affecting the price).

Case C: Increased Trading Activity Makes Shares Readily Convertible to Cash After Contract Inception

55-88 A nontransferable forward contract on a public entity’s stock provides for delivery on a single date of a significant number of shares that, at the inception of the contract, would significantly affect the price of the public entity’s stock in the market if sold within a few days. As a result, the contract does not satisfy the readily-convertible-to-cash criterion. However, at some later date, the trading activity of the public entity’s stock increases significantly. Upon a subsequent evaluation of whether the shares are readily convertible to cash, the number of shares to be delivered would be minimal in relation to the new average daily trading volume such that the contract would then satisfy the net settlement characteristic.

Case D: Delisting Makes Shares Not Readily Convertible to Cash After Contract Inception

55-89 A nontransferable forward contract on a public entity’s stock meets the net settlement criteria (as discussed beginning in paragraph 815-10-15-119) in that, at inception of the contract, the shares are expected to be readily convertible to cash when delivered under the contract. Assume that there is no other way that the contract meets the net settlement criteria. The public entity subsequently becomes delisted from the stock exchange, thus causing the shares to be delivered under the contract to no longer be readily convertible to cash.

An entity should continually reassess whether an embedded feature meets the net settlement characteristic in the definition of a derivative (see Sections 8.3.4.4.5 and 8.5.4). ASC 815-10-55-87 through 55-89 highlight that such reassessment might be required for the stock underlying a contract upon its IPO, a change in its market activity, or its delisting.

8.4.7.6 Scope Exception for Certain Own Equity Contracts

8.4.7.6.1 General

ASC 815-10

15-74 Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Subtopic:

Contracts issued or held by that reporting entity that are both:
1. Indexed to its own stock (see Section 815-40-15)
2. Classified in stockholders’ equity in its statement of financial position (see Section 815-40-25). . . .

15-75A For purposes of evaluating whether a financial instrument meets the scope exception in paragraph 815-10-15-74(a)(1), a down round feature shall be excluded from the consideration of whether the instrument is indexed to the entity’s own stock.

15-76 Temporary equity is considered stockholders’ equity for purposes of the scope exception in paragraph 815-10-15-74(a) even if it is required to be displayed outside of the permanent equity section.

15-77 For guidance on determining whether a freestanding financial instrument or embedded feature is not precluded from qualifying for the first part of the scope exception in paragraph 815-10-15-74(a), see the guidance beginning in paragraph 815-40-15-5. For guidance on determining whether a freestanding financial instrument or embedded feature qualifies for the second part of the scope exception in paragraph 815-10-15-74(a), see the guidance beginning in paragraph 815-40-25-1.

15-78 Paragraph 815-40-25-39 explains that, for purposes of evaluating under this Subtopic whether an embedded derivative indexed to an entity’s own stock would be classified in stockholders’ equity if freestanding, the additional considerations necessary for equity classifications beginning in paragraph 815-40-25-7 do not apply if the hybrid contract is a convertible debt instrument in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer).

ASC 815-15

25-14 The criterion in paragraph 815-15-25-1(c) is not met if the separate instrument with the same terms as the embedded derivative would be classified as a liability (or an asset in some circumstances) under the provisions of Topic 480 but would be classified in stockholders’ equity absent the provisions in that Topic. For purposes of analyzing the application of paragraph 815-10-15-74(a) to an embedded derivative as though it were a separate instrument, paragraphs 480-10-25-4 through 25-14 shall be disregarded. Those embedded features are analyzed by applying other applicable guidance (such as the guidance in Subtopic 815-40 on contracts in entity’s own equity).

25-15 Paragraph 815-40-25-39 states that, for purposes of evaluating under paragraph 815-15-25-1 whether an embedded derivative indexed to an entity’s own stock would be classified in stockholders’ equity if freestanding, the additional considerations necessary for equity classification beginning in paragraph 815-40-25-7 do not apply if the hybrid contract is a convertible debt instrument (see paragraph 815-40-25-41) in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer). However, paragraph 815-40-25-40 states that those additional considerations do apply when an issuer is evaluating whether any embedded derivative other than those discussed in paragraph 815-40-25-39 is an equity instrument and thereby excluded from the scope of this Subtopic.

The determination of whether an embedded equity conversion feature meets the scope exception in ASC 815-10-15-74(a) for certain contracts on the entity’s own equity includes an evaluation of whether the feature is considered indexed to own equity under ASC 815-40-15 (see Section 8.4.7.6.2) and, if so, whether the feature meets additional equity classification conditions in ASC 815-40-25 (see Section 8.4.7.6.5). This section provides a brief overview of those requirements. For a comprehensive discussion of the application of this guidance, see Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

Connecting the Dots

An issuer of convertible debt must evaluate whether it is required to separately recognize the embedded conversion feature as a derivative instrument under ASC 815-15. Therefore, entities that issue convertible debt have to apply the guidance in ASC 815-40 (which is complex; see the next section) to determine whether an embedded conversion option that meets the characteristics of a derivative must be separated and accounted for as a derivative liability.

8.4.7.6.2 Determining Whether the Feature Is Indexed to Own Equity Under ASC 815-40-15

ASC 815-40

15-7 An entity shall evaluate whether an equity-linked financial instrument (or embedded feature), as discussed in paragraphs 815-40-15-5 through 15-8 is considered indexed to its own stock within the meaning of this Subtopic and paragraph 815-10-15-74(a) using the following two-step approach:

Evaluate the instrument’s contingent exercise provisions, if any.
Evaluate the instrument’s settlement provisions.

One of the conditions that must be met for an equity conversion feature to qualify for the exception related to derivative accounting in ASC 815-10-15-74(a) is that it must be indexed to the entity’s own stock under ASC 815-40-15. An entity performs a two-step analysis to determine whether this condition has been satisfied:

Step 1 — Evaluate whether the feature contains any exercise contingencies and, if so, whether they disqualify the feature from being considered indexed to the entity’s own equity (see Section 8.4.7.6.3).
Step 2 — Assess whether the settlement terms preclude the feature from being considered indexed to the entity’s own equity (see Section 8.4.7.6.4).

8.4.7.6.3 Step 1 of Indexation Analysis

ASC Master Glossary

Exercise Contingency

A provision that entitles the entity (or the counterparty) to exercise an equity-linked financial instrument (or embedded feature) based on changes in an underlying, including the occurrence (or nonoccurrence) of a specified event. Provisions that accelerate the timing of the entity’s (or the counterparty’s) ability to exercise an instrument and provisions that extend the length of time that an instrument is exercisable are examples of exercise contingencies.

ASC 815-40

15-7A An exercise contingency shall not preclude an instrument (or embedded feature) from being considered indexed to an entity’s own stock provided that it is not based on either of the following:

An observable market, other than the market for the issuer’s stock (if applicable)
An observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (for example, sales revenue of the issuer; earnings before interest, taxes, depreciation, and amortization of the issuer; net income of the issuer; or total equity of the issuer).

If the evaluation of Step 1 (this paragraph) does not preclude an instrument from being considered indexed to the entity’s own stock, the analysis shall proceed to Step 2 (see paragraph 815-40-15-7C).

The following provisions are examples of exercise contingencies:

Type	Description	Examples
Exercise condition	A provision that affects whether the conversion feature becomes exercisable.	A conversion feature that becomes exercisable upon an IPO.
Settlement condition	A provision that affects whether a conversion feature is settled.	A conversion feature that is contingent on whether revenue has exceeded a specified threshold.
Acceleration provision	A provision that accelerates the timing of either the entity’s or the counterparty’s ability to exercise the conversion feature or that accelerates the timing of its settlement.	The counterparty’s right to exercise the conversion feature is accelerated upon a merger event, tender offer, hedging disruption, loss of stock borrow, nationalization, or delisting.
Extension provision	A provision that extends the timing of either the entity’s or the counterparty’s ability to exercise the conversion feature or extends the timing of its settlement.	A provision that extends the expiration date of a conversion feature upon an IPO.
Deferral provision	A provision that defers the timing of either the entity’s or the counterparty’s ability to exercise the conversion feature or defers the timing of its settlement.	A provision that delays the counterparty’s ability to exercise a conversion feature if the entity lacks sufficient registered shares or that defers settlement if the counterparty’s ownership of shares exceeds a specified level or the counterparty needs time to unwind related hedges.
Termination provision	A provision that results in the conversion feature’s termination (also sometimes called “cancellation,” “forfeiture,” or “knock-out” provision).	A provision that terminates the conversion feature upon a change in control, IPO, or insolvency.

Some, but not all, conversion features contain exercise contingencies. The mere passage of time is not considered an exercise contingency, nor is a contingency that affects the calculation of the settlement amount of an instrument if the contingency does not alter the availability or timing of settlement (e.g., the occurrence of a specified event that affects the strike price of an equity conversion feature that was currently exercisable).

Exercise contingencies that are based on an observable market or an observable index preclude an equity conversion feature from being considered indexed to an entity’s own equity unless they are based on either of the following:

The market for the issuer’s stock, such as the following:
- A provision that permits the instrument to be converted if the entity’s stock price exceeds a certain dollar amount (a market price trigger).
- A provision that permits the instrument to be converted into the entity’s equity shares if the instrument trades for an amount that is less than a specified percentage (e.g., 98 percent) of its if-converted value (a parity provision).
An index calculated solely by reference to the issuer’s own operations, such as sales of at least $100 million.

An exercise contingency that is based on something other than an observable market or observable index does not preclude an equity conversion feature from being considered indexed to an entity’s own equity under step 1 of the indexation analysis.

The table below contains additional examples of exercise contingencies and their evaluation under step 1 of the indexation analysis.

Exercise Contingencies That Do Not Preclude Equity Classification	Exercise Contingencies That Preclude Equity Classification
Stock price of the issuer Stock price of a consolidated subsidiary that is a substantive entity Revenue, net income, or EBITDA of the issuer Net assets of the issuer Revenue, net income, or EBITDA of a consolidated subsidiary that is a substantive entity A change in control or merger involving the issuer An IPO of the issuer An exchange listing or filing of a registration statement by the issuer Delisting of the issuer An offering of additional securities by the issuer A stock split or other dilutive event carried out by the issuer Extraordinary dividends The issuer’s settlement of another outstanding security of the issuer (e.g., pursuant to exercise of a call option by the issuer or a conversion by the investor) Cost of stock borrow on the entity’s stock (including loss of stock borrow and increased cost of stock borrow) Nationalization Insolvency Change in law (e.g., a change in law that makes it illegal to be a party to the contract) Hedging disruption or increased cost of hedging related to the entity’s shares Counterparty’s level of ownership of the entity’s shares Event of default Market disruption event (e.g., extended closure of stock exchange) A parity provision (convertible instruments only) The credit rating of the issuer	Stock price of a third party Delisting of a third party Stock market index (e.g., S&P 500) Commodity price (e.g., gold, natural gas, or oil) Foreign currency rate or index Interest rate or index (e.g., LIBOR) CPI The relationship between the stock price of the issuer and a stock market index The relationship between (1) the issuer’s revenue, net income, or EBITDA and (2) the revenue, net income, or EBITDA of a competitor company

Exercise Contingencies That Do Not Preclude Equity Classification

Exercise Contingencies That Preclude Equity Classification

Stock price of the issuer
Stock price of a consolidated subsidiary that is a substantive entity
Revenue, net income, or EBITDA of the issuer
Net assets of the issuer
Revenue, net income, or EBITDA of a consolidated subsidiary that is a substantive entity
A change in control or merger involving the issuer
An IPO of the issuer
An exchange listing or filing of a registration statement by the issuer
Delisting of the issuer
An offering of additional securities by the issuer
A stock split or other dilutive event carried out by the issuer
Extraordinary dividends
The issuer’s settlement of another outstanding security of the issuer (e.g., pursuant to exercise of a call option by the issuer or a conversion by the investor)
Cost of stock borrow on the entity’s stock (including loss of stock borrow and increased cost of stock borrow)
Nationalization
Insolvency
Change in law (e.g., a change in law that makes it illegal to be a party to the contract)
Hedging disruption or increased cost of hedging related to the entity’s shares
Counterparty’s level of ownership of the entity’s shares
Event of default
Market disruption event (e.g., extended closure of stock exchange)
A parity provision (convertible instruments only)
The credit rating of the issuer

Stock price of a third party
Delisting of a third party
Stock market index (e.g., S&P 500)
Commodity price (e.g., gold, natural gas, or oil)
Foreign currency rate or index
Interest rate or index (e.g., LIBOR)
CPI
The relationship between the stock price of the issuer and a stock market index
The relationship between (1) the issuer’s revenue, net income, or EBITDA and (2) the revenue, net income, or EBITDA of a competitor company

For a comprehensive discussion of step 1 of the indexation analysis under ASC 815-40-15, see Section 4.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

8.4.7.6.4 Step 2 of Indexation Analysis

ASC 815-40

15-7C Unless paragraph 815-40-15-7A precludes it, an instrument (or embedded feature) shall be considered indexed to an entity’s own stock if its settlement amount will equal the difference between the following:

The fair value of a fixed number of the entity’s equity shares
A fixed monetary amount or a fixed amount of a debt instrument issued by the entity.

For example, an issued share option that gives the counterparty a right to buy a fixed number of the entity’s shares for a fixed price or for a fixed stated principal amount of a bond issued by the entity shall be considered indexed to the entity’s own stock.

15-7D An instrument’s strike price or the number of shares used to calculate the settlement amount are not fixed if its terms provide for any potential adjustment, regardless of the probability of such adjustment(s) or whether such adjustments are in the entity’s control. If the instrument’s strike price or the number of shares used to calculate the settlement amount are not fixed, the instrument (or embedded feature) shall still be considered indexed to an entity’s own stock if the only variables that could affect the settlement amount would be inputs to the fair value of a fixed-for-fixed forward or option on equity shares (provided that paragraph 815-40-15-7A does not preclude such a conclusion).

15-7E A fixed-for-fixed forward or option on equity shares has a settlement amount that is equal to the difference between the price of a fixed number of equity shares and a fixed strike price. The fair value inputs of a fixed-for-fixed forward or option on equity shares may include the entity’s stock price and additional variables, including all of the following:

Strike price of the instrument
Term of the instrument
Expected dividends or other dilutive activities
Stock borrow cost
Interest rates
Stock price volatility
The entity’s credit spread
The ability to maintain a standard hedge position in the underlying shares.

Determinations and adjustments related to the settlement amount (including the determination of the ability to maintain a standard hedge position) shall be commercially reasonable.

15-7F An instrument (or embedded feature) shall not be considered indexed to the entity’s own stock if its settlement amount is affected by variables that are extraneous to the pricing of a fixed-for-fixed option or forward contract on equity shares. An instrument (or embedded feature) shall not be considered indexed to the entity’s own stock if either:

The instrument’s settlement calculation incorporates variables other than those used to determine the fair value of a fixed-for-fixed forward or option on equity shares.
The instrument contains a feature (such as a leverage factor) that increases exposure to the additional variables listed in the preceding paragraph in a manner that is inconsistent with a fixed-for-fixed forward or option on equity shares.

15-7G Standard pricing models for equity-linked financial instruments contain certain implicit assumptions. One such assumption is that the stock price exposure inherent in those instruments can be hedged by entering into an offsetting position in the underlying equity shares. For example, the Black-Scholes-Merton option-pricing model assumes that the underlying shares can be sold short without transaction costs and that stock price changes will be continuous. Accordingly, for purposes of applying Step 2, fair value inputs include adjustments to neutralize the effects of events that can cause stock price discontinuities. For example, a merger announcement may cause an immediate jump (up or down) in the price of shares underlying an equity-linked option contract. A holder of that instrument would not be able to continuously adjust its hedge position in the underlying shares due to the discontinuous stock price change. As a result, changes in the fair value of an equity-linked instrument and changes in the fair value of an offsetting hedge position in the underlying shares will differ, creating a gain or loss for the instrument holder as a result of the merger announcement. Therefore, inclusion of provisions that adjust the terms of the instrument to offset the net gain or loss resulting from a merger announcement or similar event do not preclude an equity-linked instrument (or embedded feature) from being considered indexed to an entity’s own stock.

15-7H Some equity-linked financial instruments contain provisions that provide an entity with the ability to unilaterally modify the terms of the instrument at any time, provided that such modification benefits the counterparty. For example, the terms of a convertible debt instrument may explicitly permit the issuer to reduce the conversion price at any time to induce conversion of the instrument. For purposes of applying Step 2, such provisions do not affect the determination of whether an instrument (or embedded feature) is considered indexed to an entity’s own stock.

If, after performing step 1 of the indexation analysis, an entity concludes that an equity conversion feature’s exercise contingency provisions (if any) do not preclude a conclusion that the feature is indexed to the entity’s own stock, the entity must perform step 2 to evaluate the instrument’s settlement terms. Under step 2, an equity conversion feature is considered indexed to the entity’s own stock if either of the following two conditions is met:

The equity conversion feature is a “fixed-for-fixed” forward or option on equity shares. That is, the feature’s settlement amount will always equal the difference between (1) the fair value of a fixed number of the entity’s equity shares and (2) a fixed monetary amount denominated in the reporting entity’s functional currency.
The equity conversion feature is not fixed for fixed, but the only variables that could affect the feature’s settlement amount are inputs used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares.

Most equity conversion features contain provisions that adjust the conversion terms upon the occurrence of certain events. In applying step 2, an entity is required to consider any potential settlement adjustment provisions regardless of the likelihood of the occurrence of the associated event. Certain adjustments will disqualify the feature from being considered indexed to the entity’s own equity; therefore, the scope exception in ASC 815-10-15-74(a) may not be applied.

There are two types of inputs that may adjust the settlement amount of an equity conversion feature:

An explicit input is an underlying (other than the occurrence or nonoccurrence of a specified event) that could affect the settlement amount (i.e., the conversion price or the number of equity shares used to calculate the settlement amount). Examples of explicit inputs include a specific interest rate, security price, commodity price, foreign exchange rate, inflation rate, credit rating, prepayment index, or other index or indexes of specified prices or rates.
An implicit input is an assumption about the occurrence or nonoccurrence of a specified event that could affect the settlement amount (i.e., the conversion price or the number of equity shares used to calculate the settlement amount). For example, there may be an implicit assumption in the pricing of the feature that no dilutive event affecting the underlying equity securities will occur (e.g., stock split). Other examples of implicit inputs include the occurrence or nonoccurrence of the following events:
- An IPO or a subsequent offering of securities by the issuer.
- A tender offer for the securities of the issuer.
- A change of control or merger involving the issuer.
- Bankruptcy or insolvency of the issuer.
- The incurrence of transaction costs to dispose of equity securities received upon settlement of an equity-linked option.

8.4.7.6.4.1 Explicit Inputs

To evaluate whether an adjustment to the settlement amount that is based on an explicit input precludes an equity conversion feature from being considered indexed to an entity’s own stock, the entity considers the questions below, assessing each explicit input separately. If, because of an adjustment that is based on an explicit input, an entity determines that the feature is not indexed to the entity’s own stock, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a):

Is the explicit input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?

For the equity conversion feature to be considered indexed to the entity’s stock, the answer must be yes. If the answer is no, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.

If the settlement terms are adjusted in response to changes in an input used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares, those adjustments do not necessarily preclude an entity from considering the feature to be indexed to the reporting entity’s stock. If, however, the settlement amount varies in response to changes in explicit inputs other than those used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares (i.e., extraneous variables), the feature is not considered indexed to the reporting entity’s stock.

The table below lists examples of explicit inputs that may or may not preclude equity classification if an adjustment is made to the settlement amount in response to a change in the explicit input.

Permissible (Equity Classification Not Precluded)	Not Permissible (Equity Classification Precluded)
The issuer’s stock price (including a weighted-average price over a reasonable period; see Section 4.3.5.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) The stock price of a consolidated subsidiary that is a substantive entity (see Section 2.6.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) The conversion price The term of the instrument Expected dividends (see Section 4.3.5.3 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) Cost of borrowing the entity’s stock (cost of stock borrow; see Section 4.3.5.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) Risk-free interest rates (i.e., LIBOR, the federal funds rate, or the U.S. Treasury rate; see Sections 4.3.5.2, 4.3.5.9, and 4.3.5.10 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) Stock price volatility (see Section 4.3.5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) The entity’s credit spread	Revenue, net income, EBITDA, or other operating metric of the issuer (unless the formula is designed to equal or closely approximate the fair value of the entity’s stock; see Section 4.3.5.6 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) The authorized and unissued common shares of the issuer The number of outstanding common shares of the issuer (unless the terms of the instrument are adjusted solely to offset the effect of a dilutive event) A commodity price (e.g., gold; see Section 4.3.5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) A foreign currency index or rate (see Section 4.3.8 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) An inflation rate Stock option exercise behavior (see Section 4.3.5.8 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)

Permissible (Equity Classification Not Precluded)

Not Permissible (Equity Classification Precluded)

The issuer’s stock price (including a weighted-average price over a reasonable period; see Section 4.3.5.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
The stock price of a consolidated subsidiary that is a substantive entity (see Section 2.6.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
The conversion price
The term of the instrument
Expected dividends (see Section 4.3.5.3 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
Cost of borrowing the entity’s stock (cost of stock borrow; see Section 4.3.5.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
Risk-free interest rates (i.e., LIBOR, the federal funds rate, or the U.S. Treasury rate; see Sections 4.3.5.2, 4.3.5.9, and 4.3.5.10 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
Stock price volatility (see Section 4.3.5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
The entity’s credit spread

Revenue, net income, EBITDA, or other operating metric of the issuer (unless the formula is designed to equal or closely approximate the fair value of the entity’s stock; see Section 4.3.5.6 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
The authorized and unissued common shares of the issuer
The number of outstanding common shares of the issuer (unless the terms of the instrument are adjusted solely to offset the effect of a dilutive event)
A commodity price (e.g., gold; see Section 4.3.5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
A foreign currency index or rate (see Section 4.3.8 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
An inflation rate
Stock option exercise behavior (see Section 4.3.5.8 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)

Could a change in the explicit input (other than the reporting entity’s stock price) affect the settlement amount in a manner inconsistent with how a change in the input would affect the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?

For an equity conversion feature to be indexed to the entity’s stock, the answer must be no. If the answer is yes, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.

An adjustment in response to a change in an explicit input does not necessarily need to reflect the whole effect that the variable would have had on the fair value of a fixed-for-fixed forward or option on equity shares. If, however, an equity conversion contains leverage that results in greater exposure to an input (other than the reporting entity’s stock price) than the exposure to the input in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares, the feature is considered not indexed to the reporting entity’s stock. Similarly, if a change in an explicit input (other than a change based solely on the reporting entity’s stock price) affects the settlement amount of the feature in a manner inconsistent with the effect that the underlying would have on the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares (e.g., the underlying affects the settlement amount inversely), the feature is considered not indexed to the entity’s own equity.
Could a change in the explicit input (other than the reporting entity’s stock price) result in a settlement at a fixed monetary amount?

For an equity conversion feature to be indexed to the entity’s stock, the answer must be no. If the answer is yes, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification. Note, however, that an equity conversion feature that settles at a fixed monetary amount generally should be evaluated as a share-settled redemption feature, not as a conversion feature (see Sections 8.2.2 and 8.4.7.2.5).

8.4.7.6.4.2 Implicit Inputs

An entity considers the three questions below when evaluating whether adjustments to the settlement amount that are based on an implicit input preclude the equity conversion feature from qualifying for the scope exception in ASC 815-10-15-74(a). The entity evaluates each implicit input separately. These considerations are relevant regardless of whether the implicit input (1) affects the conversion price of the equity conversion feature or the number of equity shares used to calculate the settlement amount or (2) results in an immediate settlement of the feature at an adjusted settlement amount. If, because of an adjustment that is based on an implicit input, an entity determines that the feature is not indexed to the entity’s own stock, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a):

Does the adjustment to the settlement provisions result from the occurrence or nonoccurrence of a specified event that invalidates an implicit assumption used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares?

For an equity conversion feature to be indexed to the entity’s stock, the answer must be yes. If the answer is no, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.

An equity conversion feature is not indexed to the entity’s stock if its terms include an adjustment in response to the occurrence or nonoccurrence of a specified event unless the occurrence or nonoccurrence of the event is inconsistent with an implicit assumption in a standard valuation model used to determine the fair value of a fixed-for-fixed forward or option on equity shares.

The table below lists examples of events in response to which adjustments to the settlement amount may or may not preclude equity classification.

Permissible (Equity Classification Not Precluded)	Not Permissible (Equity Classification Precluded)
Dilutive events affecting the underlying shares (e.g., a stock split, subdivision, combination, reclassification, or recapitalization; see Section 4.3.7.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) A down-round protection feature (see Section 4.3.7.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) The counterparty in a gain position does not receive the full monetary value it is due upon settlement depending on the form of settlement (e.g., as a result of transaction costs related to the disposition of shares received or a discount in the value of unregistered shares; see Sections 4.3.7.6, 4.3.7.7, and 4.3.7.8 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) The counterparty is unable to participate in any extraordinary distribution of cash or noncash consideration or other similar event in which all holders of underlying shares may participate (e.g., a tender offer made by a third party) The counterparty is not able to realize the remaining time value inherent in the contract (i.e., loss of time value upon early settlement; see Section 4.3.7.10 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) The counterparty is unable to maintain a standard hedge position in the underlying shares (e.g., loss of stock borrow) The counterparty experiences a hedge disruption event because of discontinuities in the price of the underlying shares (e.g., as a result of a merger event or change in control, tender offer, termination of trading, governmental or political event, or natural disaster; see Section 4.3.7.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)	Occurrence or nonoccurrence of an IPO (unless the adjustment provision meets the definition of a down-round feature; see Section 4.3.7.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) A change in the entity’s number of authorized and unissued common shares A change in the number of outstanding common shares that occurs as a result of a specified event other than a dilutive event A provision that requires shareholder approval The entity’s bankruptcy or insolvency (unless the event results in a hedging disruption) Delisting of the underlying shares (unless the event results in a hedging disruption)

Permissible (Equity Classification Not Precluded)

Not Permissible (Equity Classification Precluded)

Dilutive events affecting the underlying shares (e.g., a stock split, subdivision, combination, reclassification, or recapitalization; see Section 4.3.7.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
A down-round protection feature (see Section 4.3.7.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
The counterparty in a gain position does not receive the full monetary value it is due upon settlement depending on the form of settlement (e.g., as a result of transaction costs related to the disposition of shares received or a discount in the value of unregistered shares; see Sections 4.3.7.6, 4.3.7.7, and 4.3.7.8 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
The counterparty is unable to participate in any extraordinary distribution of cash or noncash consideration or other similar event in which all holders of underlying shares may participate (e.g., a tender offer made by a third party)
The counterparty is not able to realize the remaining time value inherent in the contract (i.e., loss of time value upon early settlement; see Section 4.3.7.10 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
The counterparty is unable to maintain a standard hedge position in the underlying shares (e.g., loss of stock borrow)
The counterparty experiences a hedge disruption event because of discontinuities in the price of the underlying shares (e.g., as a result of a merger event or change in control, tender offer, termination of trading, governmental or political event, or natural disaster; see Section 4.3.7.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)

Occurrence or nonoccurrence of an IPO (unless the adjustment provision meets the definition of a down-round feature; see Section 4.3.7.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity)
A change in the entity’s number of authorized and unissued common shares
A change in the number of outstanding common shares that occurs as a result of a specified event other than a dilutive event
A provision that requires shareholder approval
The entity’s bankruptcy or insolvency (unless the event results in a hedging disruption)
Delisting of the underlying shares (unless the event results in a hedging disruption)

Is the adjustment to the settlement terms consistent with the effect that the occurrence or nonoccurrence of the specified event had on the fair value of the equity conversion feature (i.e., does the adjustment offset — at least partially — the net gain or loss on the equity conversion feature that occurs as a result of the specified event)?

For an equity conversion feature to be indexed to the entity’s stock, the answer must be yes. If the answer is no, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.

An equity conversion feature is not indexed to the entity’s stock if its terms include an adjustment in response to the occurrence or nonoccurrence of a specified event that is inconsistent with an implicit assumption in a standard valuation model unless the adjustment is consistent with the effect that the occurrence or nonoccurrence of the specified event has on the fair value of the instrument. Thus, adjustments to neutralize or partially offset the effects of events that invalidate an implicit assumption in a valuation model do not preclude an equity conversion feature from being indexed to the entity’s stock. In this context, “neutralize” means that the calculation of the adjustment to the settlement terms of the equity conversion feature appropriately offsets the net gain or loss on the feature that occurred as a result of the specified event.

Adjustments from implicit inputs do not necessarily have to result in a complete neutralization of the effect that the occurrence or nonoccurrence of a specified event has on the fair value of the equity conversion feature (i.e., the net gain or loss on the feature that occurs as a result of the specified event). However, an adjustment to the terms of an equity conversion feature to reflect more than 100 percent of the effect that the variable has on the fair value of a fixed-for-fixed forward or option on equity shares precludes the equity conversion feature from being indexed to the entity’s stock because the additional exposure is inconsistent with a fixed-for-fixed forward or option on equity shares.

Note that a contract may be considered indexed to the entity’s stock even if no adjustments are made upon the occurrence or nonoccurrence of an event that invalidates an implicit assumption. In a fixed-for-fixed forward or option on equity shares, no adjustments are made upon the occurrence of an event that is inconsistent with any of the implicit assumptions. Instead, the counterparty to the instrument is exposed to the risk of a change in the fair value of the instrument upon the occurrence or nonoccurrence of such events. Further, an equity conversion feature may be considered indexed to the entity’s stock even if an adjustment upon the occurrence or nonoccurrence of an event that invalidates an implicit assumption only partially offsets the effect of the specified event.

For an equity conversion feature to qualify as equity, an adjustment cannot compensate the counterparty for adverse changes in the entity’s share price that are not attributable to the effect of the specified event. This is because such an adjustment could “protect” the counterparty from an adverse price change that results from events other than an event that invalidates an implicit assumption. Similarly, an adjustment based on the difference between the pre-event share price and the post-event share price generally would preclude equity classification because the share price could have changed for reasons other than the event itself (ASC 815-40-55-42). The principle is that an adjustment should be designed to capture only the theoretical effect of the event that invalidates an implicit assumption (e.g., a dilutive event).

A settlement of an equity conversion feature at its fair value as of the settlement date (i.e., that reflects the effect of a specified event) is not considered to have been affected by an implicit input because no additional value is exchanged between the counterparties (i.e., no adjustment is made for the net gain or loss resulting from the invalidation of an implicit input).
Could a change in an implicit input result in a settlement at a fixed monetary amount?

For an equity conversion feature to be indexed to the entity’s stock, the answer must be no. If the answer is yes, the equity conversion feature does not qualify for the scope exception in ASC 815-10-15-74(a) irrespective of whether it meets the other conditions for equity classification.

If a change in an implicit input can result in a settlement that is based on a fixed monetary amount, the equity conversion feature is not indexed to the reporting entity’s stock. This is because the occurrence of the specified event would result in a settlement amount that would be inconsistent with the effect that the event would have had on the fair value of a fixed-for-fixed forward or option on equity shares. Note, however, that an equity conversion feature that settles at a fixed monetary amount generally should be evaluated as a share-settled redemption feature, not as a conversion feature (see Sections 8.2.2 and 8.4.7.2.5).

Example 8-20

Convertible Debt With a Share-Settled Redemption Feature

An entity has issued a debt instrument with a principal amount of $10 million that is automatically converted into the issuer’s equity shares upon an IPO. The conversion price is the lower of 80 percent of the stock price in the IPO or $50. Although the conversion price in this scenario is reduced to the IPO price if the IPO price is below $50, the potential adjustment is not a down-round feature because the associated settlement has a monetary value equal to a fixed monetary amount ($10,000,000 ÷ 80% = $12,500,000). The entity should evaluate this share-settled redemption feature in a manner similar to how it evaluates a put or call option embedded in a debt host contract to determine whether the feature must be separated as a derivative under ASC 815-15 (see Section 8.4.7.2.5).

Example 8-21

Convertible Debt With Down-Round Feature

An entity has issued a 10-year convertible debt instrument with a principal amount of $10 million. The conversion price is $50. If an IPO were to occur with an IPO price of less than $50, the conversion price would be reduced to the IPO price. The holder is not required to convert the debt upon an IPO; it can continue to hold the debt and elect to convert it later. In such a scenario, the potential adjustment to the conversion price upon an IPO is a down-round feature because the conversion feature has a monetary value that varies on the basis of changes in the issuer’s stock price both before and after the IPO.

Example 8-22

Convertible Debt With Make-Whole Conversion Shares

Entity A has issued convertible notes. Each note is convertible into A’s common stock at the holder’s election at a conversion rate of 15 shares of common stock per $1,000 principal amount of notes. The terms of the notes specify that if a change in control or sale of substantially all of A’s assets occurs and the holder elects to convert, A will adjust the conversion rate by increasing the number of shares that will be delivered upon conversion. The number of additional shares, if any, that will be delivered is determined by reference to the make-whole table below on the basis of (1) the effective date on which the transaction occurs and (2) the stock price as of that date. The adjustment to the conversion rate is designed to compensate the holder for the expected option value that the holder would lose as a result of the transaction. That is, the adjustment is intended to make the holder whole for the expected loss of the time value of money that would result from an early exercise of the conversion option. Accordingly, the aggregate fair value of the shares deliverable (including the make-whole shares) upon conversion is expected to approximate the fair value of the conversion option on the settlement date as long as there has been no change in relevant pricing inputs (other than stock price and time) since the instrument’s inception. In no event will the conversion rate be increased to exceed 20.36 shares of common stock per $1,000 principal amount of notes.

In the make-whole table above, the conversion option is not precluded from being indexed to A’s stock because the adjustment (1) results from the occurrence of an event that invalidates an implicit assumption used in the pricing of a fixed-for-fixed option on equity shares (i.e., that the holder will realize the remaining time value inherent in the notes), (2) is directionally consistent with compensating the holders for lost time value (i.e., the number of additional shares that will be delivered is reduced as the stock price increases and as time to maturity decreases), (3) does not protect the holder from an adverse price change that is unrelated to the event, (4) is not leveraged (i.e., does not contain compensation in excess of expected lost time value), and (5) does not result in the delivery of shares worth a fixed monetary amount.

If an entity concludes that an equity conversion feature is indexed to its own stock under ASC 815-40-15, the entity would also need to assess whether the equity classification conditions in ASC 815-40-25 are met to determine whether it can apply the scope exception in ASC 815-10-15-74(a) (see the next section).

For a comprehensive discussion of step 2 of the indexation analysis under ASC 815-40-15, see Section 4.3 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

8.4.7.6.5 Determining Whether the Feature Meets the Equity Classification Conditions in ASC 815-40-25

ASC 815-40

25-7 Contracts that include any provision that could require net cash settlement cannot be accounted for as equity of the entity (that is, asset or liability classification is required for those contracts), except in those limited circumstances in which holders of the underlying shares also would receive cash (as discussed in the following two paragraphs and paragraphs 815-40-55-2 through 55-6).

25-8 Generally, if an event that is not within the entity’s control could require net cash settlement, then the contract shall be classified as an asset or a liability. However, if the net cash settlement requirement can only be triggered in circumstances in which the holders of the shares underlying the contract also would receive cash, equity classification is not precluded.

25-9 This Subtopic does not allow for an evaluation of the likelihood that an event would trigger cash settlement (whether net cash or physical), except that if the payment of cash is only required upon the final liquidation of the entity, then that potential outcome need not be considered when applying the guidance in this Subtopic.

25-10 Because any contract provision that could require net cash settlement precludes accounting for a contract as equity of the entity (except for those circumstances in which the holders of the underlying shares would receive cash, as discussed in paragraphs 815-40-25-8 through 25-9 and paragraphs 815-40-55-2 through 55-6), all of the following conditions must be met for a contract to be classified as equity:

Subparagraph superseded by Accounting Standards Update No. 2020-06.
Entity has sufficient authorized and unissued shares. The entity has sufficient authorized and unissued shares available to settle the contract after considering all other commitments that may require the issuance of stock during the maximum period the derivative instrument could remain outstanding.
Contract contains an explicit share limit. The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
No required cash payment (with the exception of penalty payments) if entity fails to timely file. There is no requirement to net cash settle the contract in the event the entity fails to make timely filings with the Securities and Exchange Commission (SEC).
No cash-settled top-off or make-whole provisions. There are no cash settled top-off or make-whole provisions.
Subparagraph superseded by Accounting Standards Update No. 2020-06.
Subparagraph superseded by Accounting Standards Update No. 2020-06.

Paragraphs 815-40-25-39 through 25-42 explain the application of these criteria to conventional convertible debt and other hybrid instruments.

25-10A The following conditions are not required to be considered in an entity’s evaluation of net cash settlement (that is, if any one of these provisions is in a contract [or the contract is silent on these points], they should not preclude equity classification, except as described below):

Whether settlement is required in registered shares, unless the contract explicitly states that an entity must settle in cash if registered shares are unavailable. Requirements to deliver registered shares do not, by themselves, imply that an entity does not have the ability to deliver shares and, thus, do not require a contract that otherwise qualifies as equity to be classified as a liability.
Whether counterparty rights rank higher than shareholder rights. If the provisions of the contract indicate that the counterparty has rights that rank higher than the rights of a shareholder of the stock underlying the contract, this provision does not preclude equity classification.
Whether collateral is required. A provision requiring the entity to post collateral at any time for any reason does not preclude equity classification.

For an equity conversion feature to qualify for the scope exception in ASC 815-10-15-74(a), the feature must require or permit the debtor to settle the feature either physically or net in shares. Any provision that could require the issuer to net cash settle the conversion feature precludes application of the own-equity scope exception with limited exceptions. The likelihood of an event that would trigger a net cash settlement does not matter.

However, a contractual term that could require the equity conversion feature to be net cash settled is permitted if:

The event that would cause net cash settlement is within the entity’s control (see Section 5.2.3.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
The feature is required to be net cash settled only upon the final liquidation of the entity (see Section 5.2.3.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
The feature is required to be net cash settled only if holders of the shares underlying the contract would also receive cash in exchange for their shares (see Section 5.2.3.3 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity), such as upon a change of control (see Section 5.2.3.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity) or upon nationalization or expropriation (see Section 5.2.3.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity).

Some convertible debt instruments give the investor a share-settled equity conversion option and a cash-settled redemption option with a redemption amount that is the greater of the fair value of the underlying shares or the face amount of the securities. In such a scenario, the “greater-of” redemption option effectively gives the security’s holder the ability to net cash settle the embedded conversion option. Accordingly, the conversion option does not qualify as equity under ASC 815-40.

Even if a contract ostensibly requires or permits an entity to settle in shares, the entity cannot assume that it has the ability to do so unless there are no circumstances in which it could be forced to net cash settle the equity conversion feature. If such circumstances exist, equity classification is generally prohibited unless any of the exceptions in ASC 815-40-25-10A are met. For an entity to conclude that it cannot be required to net cash settle a contract, the entity must ensure that the conditions in ASC 815-40-25-10 are met. These conditions address whether there are any circumstances under which the issuer could be forced to net cash settle the contract given the contract’s terms and the regulatory and legal framework.

ASC 815-40

25-39 For purposes of evaluating under paragraph 815-15-25-1 whether an embedded derivative indexed to an entity’s own stock would be classified in stockholders’ equity if freestanding, the requirements of paragraphs 815-40-25-7 through 25-30 and 815-40-55-2 through 55-6 do not apply if the hybrid contract is a convertible debt instrument in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer).

25-40 However, the requirements of paragraphs 815-40-25-7 through 25-30 and 815-40-55-2 through 55-6 do apply if an issuer is evaluating whether any other embedded derivative is an equity instrument and thereby excluded from the scope of Subtopic 815-10.

25-41 Instruments that provide the holder with an option to convert into a fixed number of shares (or equivalent amount of cash at the discretion of the issuer) for which the ability to exercise the option is based on the passage of time or a contingent event shall qualify for the exceptions included in paragraph 815-40-25-39. Standard antidilution provisions contained in an instrument do not preclude a conclusion that the instrument is convertible into a fixed number of shares.

The conditions in ASC 815-40-25-10 do not apply to an embedded conversion option that meets the exception for certain types of convertible debt in ASC 815-40-25-39. Thus, a conversion option in such a convertible debt instrument may fail to meet one or more of those conditions and still qualify for the scope exception in ASC 815-10-15-74(a). As explained in ASC 815-40-25-39, the requirements in ASC 815-40-25-7 through 25-30 and ASC 815-40-55-2 through 55-6 do not apply to “a convertible debt instrument in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer).” Thus, for such an instrument, the issuer must have the ability to settle it gross by delivering a fixed number of shares, although the issuer might alternatively elect to settle the instrument in an equivalent amount of cash. The holder’s ability to exercise the conversion option may be “based on the passage of time or a contingent event” (ASC 815-40-25-41). For further discussion of the evaluation of this exception, see Section 5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

For a comprehensive discussion of the equity classification conditions in ASC 815-40-25, see Chapter 5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

8.4.7.7 Scope Exception for Certain Share-Based Payment Transactions

ASC 815-10

15-74 Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Subtopic: . . .

b. Contracts issued by the entity that are subject to Topic 718. If any such contract ceases to be subject to Topic 718 in accordance with paragraphs 718-10-35-9 through 35-14, the terms of that contract shall then be analyzed to determine whether the contract is subject to this Subtopic. An award that ceases to be subject to Topic 718 in accordance with those paragraphs shall be analyzed to determine whether it is subject to this Subtopic. . . .

Under ASC 718, share-based payment arrangements generally remain within the scope of ASC 718 throughout their lives, provided that they are not modified after they are issued to grantees.

Connecting the Dots

Convertible instruments granted to nonemployees in a share-based payment transaction remain within the scope of ASC 718 after vesting. A convertible instrument could become subject to the guidance in U.S. GAAP that applies to financial instruments only if (1) the instrument is modified after vesting and (2) the nonemployee is no longer providing goods or services or is no longer a customer (see ASC 718-10-35-10).

8.4.8 Foreign Currency Features

8.4.8.1 Background

This section discusses the analysis of whether a feature whose value changes on the basis of changes in one or more foreign currency exchange rates should be separated from a debt host contract and accounted for as a derivative. For example, some debt instruments contain an option to convert principal or interest payments or both at a fixed foreign currency exchange rate. Further, the terms of some debt instruments (e.g., dual currency bonds) have principal and interest payments denominated in different currencies.

This section does not apply to a feature that does not present an exposure to the risk of changes in the exchange rate of foreign currency that is different from the currency in which the debt is denominated, such as certain currency conversion convenience clauses (see Section 8.4.8.6). Further, it does not apply to debt merely by virtue of the denomination of such debt in a currency that is different from the debtor’s functional currency unless the debt contains one or more features that are denominated in a currency that is different from that in which the debt was denominated (e.g., a foreign currency option).

8.4.8.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a foreign currency feature embedded in a debt host contract. Further, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	Yes	A feature that presents an exposure to changes in the exchange rate of foreign currency that is different from the debt’s currency of denomination is not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	Yes	A feature that presents an exposure to changes in a foreign currency exchange rate meets the definition of a derivative (see Section 8.4.8.4).
Meets a scope exception (see Section 8.3.5)	It depends	The debtor should evaluate whether the foreign currency feature is exempt from derivative accounting under ASC 815-15-15-5 (see Section 8.4.8.5).

As shown in the table above, a debtor’s determination of whether a foreign currency feature must be bifurcated from a debt host contract and accounted for as derivative tends to focus on whether the feature meets a scope exception related to derivative accounting (see Section 8.4.8.5) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3). Typically, such features meet the definition of a derivative (see Section 8.4.8.4) and are not clearly and closely related to a debt host (see the next section).

8.4.8.3 Clearly-and-Closely-Related Analysis

A feature that presents an exposure to changes in the exchange rate of foreign currency that is different from the debt’s currency of denomination is not clearly and closely related to a debt host. As noted in ASC 815-15-55-212, for example, a “foreign currency option is not clearly and closely related to issuing a loan.” However, this guidance does not apply to a feature that does not present an exposure to the risk of changes in the exchange rate of foreign currency that is different from the currency in which the debt is denominated (see Section 8.4.8.6).

8.4.8.4 Derivative Analysis

The table below presents an analysis of whether a foreign currency feature embedded in a debt host contract meets the definition of a derivative. Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	An embedded feature that presents an exposure to changes in a foreign currency exchange rate that is based on a currency that is different from the debt’s currency of denomination has both an underlying (the foreign currency rate) and a notional amount (e.g., the debt’s outstanding amount).
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in a feature that presents an exposure to changes in a foreign currency exchange rate that is based on a currency that is different from the debt’s currency of denomination is its fair value (i.e., the amount that would need to be paid to acquire the feature on a stand-alone basis without the host contract). This feature has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in foreign currency exchange rates.
Net settlement (see Section 8.3.4.4)	Yes	A foreign currency feature meets the net settlement condition because it is net cash settled.

As shown in the table above, a foreign currency feature embedded in a debt host contract meets the definition of a derivative. Therefore, the analysis of whether such a feature must be bifurcated as a derivative tends to focus on whether the feature is exempt from the scope of derivative accounting (see Section 8.4.8.5) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).

8.4.8.5 Exception for Certain Foreign Currency Features

ASC 815-15

15-5 Unsettled foreign currency transactions, including financial instruments, shall not be considered to contain embedded foreign currency derivatives under this Subtopic if the transactions meet all of the following criteria:

They are monetary items.
They have their principal payments, interest payments, or both denominated in a foreign currency.
They are subject to the requirement in Subtopic 830-20 to recognize any foreign currency transaction gain or loss in earnings.

Case Q: Dual Currency Bond

55-209 A dual currency bond provides for repayment of principal in U.S. dollars and periodic interest payments denominated in a foreign currency. In this circumstance, a U.S. entity with the dollar as its functional currency is borrowing funds from an independent party with those repayment terms as described.

55-210 Because the portion of this instrument relating to the periodic interest payments denominated in a foreign currency is subject to the requirement in Topic 830 to recognize the foreign currency transaction gain or loss in earnings, the instrument should not be considered as containing an embedded foreign currency derivative instrument pursuant to paragraph 815-15-15-5. In this circumstance, the U.S. entity has the dollar as the functional currency and is making interest payments in a foreign currency. Remeasurement of the liability is required using future equivalent dollar interest payments determined by the current spot exchange rate and discounted at the historical effective interest rate.

Case R: Short-Term Loan With a Foreign Currency Option

55-211 A U.S. lender issues a loan at an above-market interest rate. The loan is made in U.S. dollars, the borrower’s functional currency, and the borrower has the option to repay the loan in U.S. dollars or in a fixed amount of a specified foreign currency.

55-212 This instrument can be viewed as combining a loan at prevailing market interest rates and a foreign currency option. The lender has written a foreign currency option exposing it to changes in foreign currency exchange rates during the outstanding period of the loan. The premium for the option has been paid as part of the interest rate. Because the borrower has the option to repay the loan in U.S. dollars or in a fixed amount of a specified foreign currency, the provisions of paragraph 815-15-15-5 are not relevant to this Case. That paragraph addresses foreign-currency-denominated interest or principal payments but does not apply to foreign currency options embedded in a functional-currency-denominated debt host contract. Because a foreign currency option is not clearly and closely related to issuing a loan, the embedded option should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic. In contrast, if both the principal payment and the interest payments on the loan had been payable only in a fixed amount of a specified foreign currency, there would be no embedded foreign currency derivative pursuant to this Subtopic.

Under ASC 815-15-15-5, debt with principal or interest payments (or both) that are denominated in a foreign currency is deemed not to contain an embedded foreign currency derivative if the amounts that are denominated in a foreign currency must be remeasured at spot rates under ASC 830-20 (see Section 14.2.3). If the interest payments of a dual-currency bond whose principal is denominated in dollars are denominated in a different currency, for example, ASC 815-15-55-210 requires the interest payments to be accounted for by discounting the “future equivalent dollar interest payments determined by the current spot exchange rate” at the debt’s original effective interest rate. Under the interest method, the principal payment would also be discounted by using the debt’s original effective interest rate (see Section 6.2).

The exemption in ASC 815-15-15-5 does not apply to a foreign currency feature that is not required to be remeasured under ASC 830-20 for changes in spot foreign currency exchange rates. For example, the exemption does not apply to an option to pay principal or interest payments in one or more alternative currencies other than the debt’s currency of denomination unless the amount owed in the alternative currency is determined by applying the current spot exchange rate at the time of payment to the amount owed in the debt’s currency of denomination (see the next section).

8.4.8.6 Convenience Clauses That Do Not Present a Foreign Currency Exposure

Sometimes, debt contracts contain a convenience clause that permits or requires principal or interest payments or both to be made in a currency that is different from that in which the debt is denominated. The amount of the payment is determined by applying the current spot foreign currency exchange rate at the time of payment to the amount owed in the debt’s currency of denomination. For example, the terms of a debt instrument denominated in USD might specify that payments may be made in one or more currencies at the current spot exchange rate at the time of payment. Such a clause does not represent a foreign currency feature that should be evaluated for bifurcation since its monetary value does not vary on the basis of a foreign currency exchange rate.

8.4.9 Payment Features Indexed to Commodities or Other Nonfinancial Items

8.4.9.1 Background

This section discusses the analysis of whether payment features that are indexed to the price or value of a commodity or other nonfinancial item (e.g., a commodity-indexed principal or interest payment or a participating mortgage feature) should be separated from a debt host contract and accounted for as derivatives under ASC 815-15.

8.4.9.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a payment feature indexed to the price or value of a commodity or other nonfinancial item. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	Yes	The price or value of a commodity or other nonfinancial item is not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	Yes	Payments indexed to the price or value of a commodity or other nonfinancial item meet the definition of a derivative.
Meets a scope exception (see Section 8.3.5)	It depends	ASC 815 contains a scope exception related to certain non-exchange-traded contracts with payments that are based on the price or value of a nonfinancial item of one of the parties to the contract provided that the asset is not readily convertible to cash (see Section 8.4.9.5).

As shown in the table above, a debtor’s determination of whether a payment feature indexed to a commodity or other nonfinancial item must be bifurcated as a derivative tends to focus on whether the feature is exempt from the scope of derivative accounting (see Section 8.4.9.5), unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3). Such a feature is not clearly and closely related to a debt host and typically meets the definition of a derivative (see Section 8.4.9.4).

8.4.9.3 Clearly-and-Closely-Related Analysis

ASC 815-15

25-48 The changes in fair value of a commodity (or other asset) and the interest yield on a debt instrument are not clearly and closely related. Thus, a commodity-related derivative instrument embedded in a commodity-indexed debt instrument shall be separated from the noncommodity host contract and accounted for as a derivative instrument.

Case J: Crude Oil Knock-In Note

55-194 An illustrative crude oil knock-in note has a 1 percent coupon and guarantees repayment of principal with upside potential based on the strength of the oil market.

55-195 A crude oil knock-in note essentially combines an interest-bearing instrument with a series of option contracts. A significant portion of the coupon interest rate is, in effect, used to purchase options that provide the investor with potential gains resulting from increases in specified crude oil prices. Because the option contracts are indexed to the price of crude oil, they are not clearly and closely related to an investment in an interest-bearing note. Therefore, the embedded option contract should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

Case K: Gold-Linked Bull Note

55-196 An illustrative gold-linked bull note has a fixed 3 percent coupon and guarantees repayment of principal with upside potential if the price of gold increases.

55-197 A gold-linked bull note can be viewed as combining an interest-bearing instrument with a series of option contracts. A portion of the coupon interest rate is, in effect, used to purchase call options that provide the investor with potential gains resulting from increases in gold prices. Because the option contracts are indexed to the price of gold, they are not clearly and closely related to an investment in an interest-bearing note. Therefore, the embedded option contracts should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

A feature that adjusts the payments of a debt contract on the basis of the price or value of a commodity or other nonfinancial item is not clearly and closely related to a debt host. This determination applies irrespective of whether the debtor owns the commodity or other nonfinancial item.

8.4.9.4 Derivative Analysis

The table below presents an analysis of whether a payment feature indexed to a commodity or other nonfinancial item meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	A feature that could adjust the payments of a debt host contract on the basis of the price or value of a commodity or other nonfinancial item has both an underlying (the item’s price or value) and a notional amount (e.g., the debt’s outstanding amount).
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the feature on a stand-alone basis without the host contract). Generally, a feature indexed to a commodity or other nonfinancial asset has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the price or value of the nonfinancial asset (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	Yes	Adjustments to the payments of a debt host contract that are indexed to the price or value of a commodity or other nonfinancial item meet the net settlement condition since 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 feature’s notional amount. (If the feature must be settled by delivery of the underlying nonfinancial item, however, the considerations in Section 8.4.7.5 apply.)

As shown in the table above, a payment feature indexed to the price or value of a nonfinancial asset typically meets the definition of a derivative. Because such a feature is not clearly and closely related to a debt host, the debtor must assess whether it qualifies for a scope exception (see the next section) unless the debtor has elected to account for the debt under the fair value option in ASC 815-15 or ASC 825-10 (see Section 8.3.3).

8.4.9.5 Scope Exception for Certain Nonfinancial Items of One of the Parties

ASC 815-10

15-59 Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following: . . .

b. The price or value of a nonfinancial asset of one of the parties to the contract provided that the asset is not readily convertible to cash. This scope exception applies only if both of the following are true:

1. The nonfinancial assets are unique.

2. The nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset. (If the contract is a call option, the scope exception applies only if that nonfinancial asset is owned by the party that would not benefit under the contract from an increase in the fair value of the nonfinancial asset above the option’s strike price.)

c. The fair value of a nonfinancial liability of one of the parties to the contract provided that the liability does not require delivery of an asset that is readily convertible to cash. . . .

15-60 If a contract has more than one underlying and some, but not all, of them qualify for one of the scope exceptions in the preceding paragraph, the application of this Subtopic to that contract depends on its predominant characteristics. That is, the contract is subject to the requirements of this Subtopic if all of its underlyings, considered in combination, behave in a manner that is highly correlated with the behavior of any of the component variables that do not qualify for a scope exception.

Example 14: Certain Contracts That Are Not Traded on an Exchange — Nonfinancial Asset of One of the Parties to a Contract

55-142 This Example addresses the application of the scope exception in paragraph 815-10-15-59(b). Entity A enters into a non-exchange-traded forward contract to buy from Entity B 100 interchangeable (fungible) units of a nonfinancial asset that are not readily convertible to cash. The contract permits net settlement through its default provisions. Entity A already owns more than 100 units of that nonfinancial asset, but Entity B does not own any units of that nonfinancial asset.

55-143 The scope exception in paragraph 815-10-15-59(b) does not apply to the accounting for the contract for both of the following reasons:

The contract’s settlement is based on an underlying associated with a nonfinancial asset that is not unique (because it is based on the price or value of an interchangeable, nonfinancial unit).
The entity that owns the nonfinancial asset related to the underlying (that is, Entity A) is the buyer of the units and thus would benefit from the forward contract if the price or value increases.

Consequently, neither Entity A nor Entity B qualifies for the scope exception in paragraph 815-10-15-59(b).

ASC 815-10-15-59 contains a scope exception for certain non-exchange-traded contracts whose settlement is based on the price or value of a nonfinancial asset of one of the parties to the contract (i.e., property owned by the debtor) or the fair value of a nonfinancial liability of one of the parties to the contract. This scope exception is not available for underlyings associated with nonfinancial assets that are readily convertible to cash or that are not unique (e.g., fungible, interchangeable items).

Original works of art or real estate would be considered unique nonfinancial assets (i.e., they do not have interchangeable units). Assets newly produced on an assembly line (have not been used) and are available from multiple sellers are not unique since a new asset is interchangeable with another new asset from the same production. However, once the manufactured asset has been used, the asset would be considered unique (e.g., a used car is considered unique).

Further, the scope exception for certain nonfinancial assets of one of the parties is only available if the nonfinancial asset is owned by the party that would not benefit under the contract from an increase in the price or value of the nonfinancial asset. In other words, the scope exception is not available if the contract benefits the owner of the nonfinancial asset when the fair value of the nonfinancial asset increases. For example, the scope exception is not available if payments required under a debt obligation decrease when the fair value of a nonfinancial asset owned by the debtor increases (i.e., the owner of the nonfinancial asset — the debtor — benefits under the contract from an increase in the fair value of the asset because such increase results in a decrease in the payments to be made on the debt obligation).

ASC 815-15

55-8 Under an example participating mortgage, the investor receives a below-market interest rate and is entitled to participate in the appreciation in the fair value of the project that is financed by the mortgage upon sale of the project, at a deemed sale date, or at the maturity or refinancing of the loan. The mortgagor must continue to own the project over the term of the mortgage.

55-9 This instrument has a provision that entitles the investor to participate in the appreciation of the referenced real estate (the project). However, a separate contract with the same terms would be excluded by the exception in paragraph 815-10-15-59(b) because settlement is based on the value of a nonfinancial asset of one of the parties that is not readily convertible to cash. (This Subtopic does not modify the guidance in Subtopic 470-30.)

55-10 Paragraph 310-10-05-9 explains that loans granted to acquire operating properties sometimes grant the lender a right to participate in expected residual profit from the sale or refinancing of the property. An equity kicker (or expected residual profit) would typically not be separated from the host contract and accounted for as an embedded derivative because paragraph 815-15-25-1(c) exempts a hybrid contract from bifurcation if a separate instrument with the same terms as the embedded equity kicker is not a derivative instrument subject to the requirements of this Subtopic. Under paragraph 815-10-15-59(b), an embedded equity kicker would typically not be subject to the requirements of this Subtopic because the separate instrument with the same terms is not exchange traded and is indexed to nonfinancial assets that are not readily convertible to cash. Similarly, if an equity kicker is based on a share in net earnings or operating cash flows, it would also typically qualify for the scope exception in paragraph 815-10-15-59(d). If the embedded derivative does not need to be accounted for separately under this Subtopic, the Acquisition, Development, and Construction Arrangements Subsections of Subtopic 310-10 shall be applied.

An example of a feature for which the scope exception in ASC 815-10-15-59 would typically be available is the participation feature in a participating mortgage, which would instead be accounted for under ASC 470-30 (see Section 7.3).

8.4.10 Revenue-Based Payments

8.4.10.1 Background

This section discusses payment features that are based on specified volumes of sales or service revenues. For example, some debt instruments require payments that are indexed to revenues from the sale of goods or services or from royalty income.

8.4.10.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a payment feature indexed to specified volumes of sales or service revenues of one of the parties to the contract. However, an entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	Yes	Payments that are based on specified volumes of sales or service revenues are not clearly and closely related to a debt host (see Section 8.4.10.3).
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	Yes	Payment features that are based on specified volumes of sales or service revenues meet the definition of a derivative.
Meets a scope exception (see Section 8.3.5)	It depends	ASC 815 contains a scope exception for non-exchange-traded contracts with payments based on specified volumes of sales or service revenues of one of the parties to the contract (see Section 8.4.10.5).

As shown in the table above, a debtor should evaluate whether a revenue-based payment feature is exempt from the scope of derivative accounting (see Section 8.4.10.5) since such features are not clearly and closely related to a debt host and meet the definition of a derivative.

8.4.10.3 Clearly-and-Closely-Related Analysis

Although ASC 815-15 does not specifically address whether a revenue-based payment feature is clearly and closely related to a debt host, the economic characteristics and risks of a payment feature indexed to specified volumes or sales or service revenues would not be considered clearly and closely related to the economic characteristics and risks of a debt instrument (i.e., interest rates, credit risk, and inflation rates). Note that for this purpose, a revenue-based feature does not include an underlying indexed to interest rates.

8.4.10.4 Derivative Analysis

The table below presents an analysis of whether a payment feature indexed to specified volumes of sales or service revenues meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	A feature that could adjust the payments of a debt host contract on the basis of specified volumes of sales or service revenues has both an underlying (specified volumes of sales or service revenues) and a notional amount (e.g., the debt’s outstanding amount) or payment provision.
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the feature on a stand-alone basis without the host contract). Generally, a feature that adjusts the payments of a debt host contract on the basis of specified volumes of sales or service revenues has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the value of the specified volumes of sales or service revenues (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	Yes	Adjustments to the payments of a debt host contract on the basis of specified volumes of sales or service revenues meet the net settlement condition because the feature is cash settled (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 feature’s notional amount).

As shown in the table above, a payment feature indexed to specified volumes of sales or service revenues typically meets the definition of a derivative. However, such a feature often qualifies for a scope exception (see the next section).

8.4.10.5 Scope Exception for Certain Revenue-Based Payments

ASC 815-10

15-59 Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following: . . .

d. Specified volumes of sales or service revenues of one of the parties to the contract. (This scope exception applies to contracts with settlements based on the volume of items sold or services rendered, for example, royalty agreements. This scope exception does not apply to contracts based on changes in sales or revenues due to changes in market prices.)

15-60 If a contract has more than one underlying and some, but not all, of them qualify for one of the scope exceptions in the preceding paragraph, the application of this Subtopic to that contract depends on its predominant characteristics. That is, the contract is subject to the requirements of this Subtopic if all of its underlyings, considered in combination, behave in a manner that is highly correlated with the behavior of any of the component variables that do not qualify for a scope exception.

ASC 815-10-15-59(d) provides a scope exception for derivatives in which the underlying is based on specified volumes of sales or service revenues of one of the parties to the contract. This scope exception in many circumstances may be applied to contracts for which the underlying is a broad performance measure of one of the parties to the contract (e.g., net earnings, EBITDA, or operating cash flows). Discussions with the FASB staff have indicated that the application of this scope exception is limited by the wording of ASC 815-10-15-59(d), which states, in part:

This scope exception does not apply to contracts based on changes in sales or revenues due to changes in market prices.

Accordingly, if the performance measure is based primarily or wholly on the volume of items sold or services rendered of one of the parties to the contract, then an embedded feature whose underlying is based on that performance measure potentially could qualify for the ASC 815-10-15-59(d) scope exception. However, the scope exception is not available if changes in the performance measure are highly correlated with changes in the market price of an asset or liability (e.g., changes in the market price of investments held or goods sold).

Example 8-23

Debt That Contains Interest Payments Indexed to EBITDA

Company H has issued debt that includes an additional interest payment based on an increase in H’s EBITDA that exceeds a specified threshold. Thus, increases in EBITDA above the threshold increase the amount of additional interest payments required. Company H determined that EBITDA is not an interest-rate index but an earnings measure that is not clearly and closely related to the debt host. Company H evaluates whether the additional interest payment feature that is based on EBITDA is an embedded derivative that must be accounted for separately.

It would be appropriate for H to apply the scope exception in ASC 815-10-15-59(d) as long as the changes in EBITDA are not primarily driven by market price changes. A contingent interest feature based on EBITDA would not qualify for the ASC 815-10-15-59(d) scope exception if changes in EBITDA are highly correlated with changes in the market price of an asset or liability (e.g., changes in the market price of investments held or goods sold).

Example 8-24

Debt With a Profit Participation Feature

A small business investment company (SBIC) issues mandatorily redeemable participating securities. The securities pay a return in the form of (1) a fixed coupon rate plus (2) a profit participation rate. The profit participation feature requires the SBIC to pay the security holders a percentage of the SBIC’s earnings on certain investments held. The investments’ earnings are based primarily on appreciation and returns generated from changes in the value of the underlying assets. In this example, the SBIC’s investment earnings are primarily driven by market price changes. In addition, the profit participation feature only applies to certain SBIC investments rather than to total company earnings, which would not constitute a “broad performance measure” of one of the parties to the contract. Therefore, the SBIC could not apply the ASC 815-10-15-59(d) scope exception.

8.4.11 Other Payment Provisions

8.4.11.1 Background

Debt instruments often contain provisions under which payments are (1) made upon the occurrence or nonoccurrence of a specified event (e.g., the debtor is late in filing financial statements) or (2) indexed to a variable (e.g., the creditor’s costs associated with a specified event) for which the accounting is not specifically addressed in ASC 815. For example, the debtor may be required to:

Pay additional interest if the debt is not freely tradable by its holders by a specified date after issuance (e.g., the debtor must pay 0.25 percent of additional interest if the debt is not freely tradable six months after issuance).
Pay additional interest if it has not filed in a timely manner any report or document that must be filed with the SEC (e.g., 0.25 percent of additional interest).
Pay additional interest if it fails to meet one or more specified environmental, social, or governance (ESG) targets (e.g., the debtor must pay additional interest of 0.50 percent if it does not use the debt proceeds to invest in renewable energy projects or fails to achieve 40 percent female representation on the debtor’s board of directors within three years of debt issuance).
Receive an interest rate reduction if it meets specified ESG targets (e.g., the stated interest rate is reduced by 0.25 percent if the debtor achieves a specified reduction in greenhouse gas emissions within three years of debt issuance).
Reimburse the creditor for increased costs as result of a specified event (e.g., a change in law or hedge disruption event).
Reimburse the creditor for taxes on interest payments.

Because payment provisions that are contingent on filing with the SEC on time or on the ability to freely trade the debt do not pertain to the filing or maintenance of either an effective registration statement or an exchange listing, they do not meet the definition of a registration payment arrangement (see Section 3.3.3.2).

Example 8-25

Debt That Requires Additional Interest to Be Paid Upon the Occurrence of Certain Events

The terms of a debt contract require the issuer to pay additional interest at a rate equal to 0.50 percent per annum of the principal amount outstanding for each day during which (1) the debtor has failed to file any document or report that the debtor is required to file with the SEC under Section 13 or 15(d) of the Securities Exchange Act of 1934 or (2) the debt is not otherwise freely tradable (e.g., eligible for sale and transfer under SEC Rule 144) as a result of restrictions in U.S. securities laws (e.g., a registration requirement under the Securities Act of 1933) or the terms of the debt indenture.

Example 8-26

Debt That Requires Additional Interest to Be Paid if Resale Is Restricted

A debt instrument was issued in accordance with an exemption from registration under the Securities Act of 1933. The terms of a debt contract require the issuer to pay additional interest at a rate equal to 0.50 percent per annum if, or for as long as, a restrictive legend on the debt has not been removed, the debt is assigned a restricted CUSIP number, or the debt is not otherwise freely tradable.

8.4.11.2 Bifurcation Analysis

The table below presents an overview of the bifurcation analysis of a payment provision that is contingent on the occurrence or nonoccurrence of a specified event (e.g., late filings) or is indexed to a variable (e.g., the creditor’s costs associated with a specified event) for which the accounting is not specifically addressed in ASC 815.

Bifurcation Condition	Condition Met?	Analysis
Not clearly and closely related (see Section 8.3.2)	Yes	Payments that are contingent on, or indexed to, an underlying other than interest rates, the debtor’s creditworthiness, or inflation are considered not clearly and closely related to a debt host.
Hybrid instrument not measured at fair value on a recurring basis (see Section 8.3.3)	It depends	Debt is not measured at fair value on a recurring basis unless the issuer elects the fair value option in ASC 815-15 or ASC 825-10 (see Sections 4.4 and 8.5.6). However, the fair value option cannot be elected for debt that contains a separately recognized equity component at inception.
Meets the definition of a derivative (see Section 8.3.4)	Yes	Generally, a feature that adjusts the payments on a debt host contract meets the definition of a derivative (see Section 8.4.11.4).
Meets a scope exception (see Section 8.3.5)	Generally, no	Although the debtor should evaluate whether any specific scope exception is available (see Section 8.3.5), often a scope exception is not available.

8.4.11.3 Clearly-and-Closely-Related Analysis

If an embedded feature is not addressed in ASC 815, an entity must apply judgment and consider the purpose of the clearly-and-closely-related criterion (e.g., whether the feature bears a close economic relationship to the host contract or is dissimilar) and analogous guidance for other types of features.

Generally, payments that are contingent on (or indexed to) an underlying other than interest rates (see Section 8.4.1), the debtor’s creditworthiness (see Section 8.4.2), or inflation (see Section 8.4.3) are considered not clearly and closely related to a debt host. In practice, the following types of payment features are typically determined to be not clearly and closely related to a debt host:

Additional interest features that are triggered if debt is not freely tradeable by a specified date or if the issuer does not file financial statements on time with the SEC.
Additional interest features that are triggered if specified ESG targets are not met.
Interest rate reductions that apply if specified ESG targets are met.
Reimbursement of creditor-related costs.
Reimbursement of taxes that the creditor owes to the government on interest paid.
Interest or principal payments that are indexed to certain ESG targets.

8.4.11.4 Derivative Analysis

The table below presents an analysis of whether a payment provision that is contingent on the occurrence or nonoccurrence of a specified event (e.g., late filings) or is indexed to a variable (e.g., the creditor’s costs associated with a specified event) for which the accounting is not specifically addressed in ASC 815 meets the definition of a derivative (see Section 8.3.4). Note, however, that an entity should always consider the terms and conditions of a specific feature in light of the applicable accounting guidance before reaching a conclusion.

Characteristics of a Derivative	Characteristic Present?	Analysis
Underlying and notional amount or payment provision (see Section 8.3.4.2)	Yes	A feature that could adjust the payments of a debt host contract on the basis of a specified event or variable has both an underlying (the specified event or variable) and a notional amount (e.g., the debt’s outstanding amount) or payment provision.
Initial net investment (see Section 8.3.4.3)	Yes	The initial net investment in an embedded feature is its fair value (i.e., the amount that would need to be paid to acquire the feature on a stand-alone basis without the host contract). Generally, a feature that adjusts the payments of a debt host contract has an initial net investment that is smaller than would be required for a direct investment that has the same exposure to changes in the value of the specified event or variable (since the investment in the debt host contract does not form part of the initial net investment for the embedded feature).
Net settlement (see Section 8.3.4.4)	Yes	A feature that adjusts payments of a debt host contract on the basis of a specified event or variable meets the net settlement condition because the feature is cash settled (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 feature’s notional amount).

As shown in the table above, a payment feature that is contingent on a specified event or indexed to a specified variable typically meets the definition of a derivative.

8.4.11.5 Additional Considerations

An entity should always consider the terms and conditions of a specific feature in light of all the relevant accounting guidance before reaching a conclusion about a payment provision (e.g., whether an exception to the guidance on derivative accounting is available; see Section 8.3.5). An entity is not required to recognize a derivative related to normal contractual remedies for a breach of contract whose occurrence the entity can prevent. For example, an entity is not required to separate an indemnification clause that holds each party harmless against damages, losses, or claims resulting from the breach of contract or gross negligence.

Depending on the likelihood that a payment feature will be triggered and, if so, on its potential amount, the fair value of a payment feature embedded in debt host might be minimal (e.g., a feature in which a minor adjustment must be made to the interest rate upon an event whose likelihood of occurring is remote). In practice, therefore, entities sometimes determine and document that they are not required to make accounting entries upon debt issuance to recognize a feature that must be bifurcated as a derivative under ASC 815-15. Any such conclusion must be appropriately supported on the basis of materiality. A determination that a feature has a minimal fair value at inception does not negate the requirement to account for it as a derivative. Accordingly, if an entity makes such a determination, it should also monitor its facts and circumstances in each reporting period to evaluate whether the feature’s fair value or change to it is significant and therefore must, under U.S. GAAP requirements, be reflected in the entity’s financial statements. For instance, if a feature that must be bifurcated as a derivative liability is determined to have a fair value that is not materially different from zero when debt is issued and the fair value increases to $50,000 during the next reporting period, the change in fair value from zero to $50,000 should be reflected as a loss during that reporting period; the change cannot be recognized as a debt discount after the issuance of the debt.

The entity should also consider the appropriate level of aggregation in identifying and evaluating embedded features (see Section 8.2). The terms of a debt contract might contain a cap on the total amount of additional interest that would be paid under additional interest provisions. For example, the debt terms might specify that in no event will additional interest be paid at a rate in excess of 0.50 percent regardless of the number of events or circumstances giving rise to the requirement to pay such additional interest. This means that the total amount of additional interest that might have to be paid on the debt is not necessarily simply the sum of the additional interest that might need to be paid under each of the provisions that triggers such additional interest payments. For instance, if one or more additional interest features have been triggered such that the total amount of additional interest payable is equal to the cap, there would be no incremental amount payable if another such feature is triggered. In this circumstance, the potential payoff of each additional interest provision and the payoffs under the other provisions to which the cap applies are interdependent. Under the payoff profile approach for identifying embedded features (see Sections 8.2.2 and 8.2.3), it is appropriate to evaluate such additional interest features as one combined embedded feature rather than as separate embedded features for each of the triggers. As a consequence, an additional interest feature that would have been considered clearly and closely related to a debt host if it had been evaluated on a stand-alone basis (e.g., an additional interest feature triggered by a change in the issuer’s creditworthiness; see Section 8.4.2) might have to be combined with other additional interest features that are not considered clearly and closely related to a debt host in the evaluation of whether the combined feature is clearly and closely related to the debt host.

8.4.12 Other Considerations

8.4.12.1 Background

This section addresses considerations applicable to:

Registration payment arrangements (see the next section).
Payments based on climatic, geological, or other physical variables (see Section 8.4.12.3).
Payments based on disaster experience (see Section 8.4.12.4).

8.4.12.2 Registration Payment Arrangements

ASC 815-10

15-82 Registration payment arrangements within the scope of Subtopic 825-20 are not subject to the requirements of this Subtopic. The exception in this paragraph applies to both the issuer that accounts for the arrangement pursuant to that Subtopic and the counterparty.

A registration payment arrangement within the scope of ASC 825-20 should not be evaluated under ASC 815 even if it is embedded in a debt host contract. Instead, it is accounted for as a separate unit of account under ASC 825-20 (see Section 3.3.3.2).

8.4.12.3 Payments Based on Climatic, Geological, or Other Physical Variables

ASC 815-10

15-59 Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following:

A climatic or geological variable or other physical variable. Climatic, geological, and other physical variables include things like the number of inches of rainfall or snow in a particular area and the severity of an earthquake as measured by the Richter scale. (See Example 13 [paragraph 815-10-55-135].) . . .

15-60 If a contract has more than one underlying and some, but not all, of them qualify for one of the scope exceptions in the preceding paragraph, the application of this Subtopic to that contract depends on its predominant characteristics. That is, the contract is subject to the requirements of this Subtopic if all of its underlyings, considered in combination, behave in a manner that is highly correlated with the behavior of any of the component variables that do not qualify for a scope exception.

ASC 815-10-15-59(a) includes a scope exception for non-exchange-traded contracts whose settlement is based on a climatic, geological, or other physical variable. Examples of payment features that may qualify for this exception include those based on measures of rainfall, snow, wind velocity, floodwater, or the severity of an earthquake or the occurrence of a hurricane. However, this scope exception is not available if the payment feature is also indexed to a financial variable, such as the dollar amount of hurricane losses (see ASC 815-10-55-137). Nevertheless, such a feature may be exempt from ASC 815 under the scope exception in ASC 815-10-15-52 through 15-57 for insurance contracts 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” (e.g., a decline in revenue as a result of a hurricane event). ASC 815-10-55-135 through 55-141 provide three examples of contracts that illustrate how to distinguish between physical and financial variables.

8.4.12.4 Payments Indexed to Disaster Experience

ASC 815-15

Case O: Disaster Bond

55-204 A disaster bond pays a coupon above that of an otherwise comparable traditional bond; however, all or a substantial portion of the principal amount is subject to loss if a specified disaster experience occurs.

55-205 A disaster bond can be viewed as a fixed-rate bond combined with a conditional exchange contract (an option contract). The investor receives an additional coupon interest payment in return for giving the issuer an option indexed to industry loss experience on a specified disaster. Because the option contract is indexed to the specified disaster experience, it cannot be viewed as being clearly and closely related to an investment in a fixed-rate bond. Therefore, the embedded derivative should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

55-206 However, if the embedded derivative entitles the holder of the option (that is, the issuer of the disaster bond) to be compensated only for changes in the value of specified assets or liabilities for which the holder is at risk (including the liability for insurance claims payable due to the specified disaster) as a result of an identified insurable event (see paragraphs 815-10-15-53 through 15-54), a separate instrument with the same terms as the embedded derivative would not meet the definition of a derivative instrument in Section 815-10-15. In that circumstance, because the criterion in paragraph 815-15-25-1(c) would not be met, there is no embedded derivative to be separated from the host contract, and the disaster bond would not be subject to the requirements of this Subtopic. The investor is essentially providing a form of insurance or reinsurance coverage to the issuer.

Sometimes, the terms of a debt instrument specify that the debtor’s obligation to pay the amount outstanding is extinguished if a specified disaster experience occurs. Although a payment feature that is indexed to disaster experience is not clearly and closely related to a host debt contract, such a feature may be exempt from ASC 815 under the scope exception in ASC 815-10-15-52 through 15-57 for insurance contracts 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.”