8.4 Application to Specific Embedded Features
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:
-
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).
-
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:
-
At prespecified payment dates
-
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.”
|
|
|
“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” (see
Section 8.4.1).
|
|
|
“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).
|
|
|
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:
-
Indexed to its own stock (see Section 815-40-15)
-
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
|
---|---|
|
|
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)
-
-
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)
-
-
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.”