8.5 Accounting for Embedded Derivatives

8.5.1 Background

This section discusses the guidance that a debtor applies when it has determined that an embedded feature must be separated from its host contract and accounted for as a derivative under ASC 815. It addresses:

Initial recognition, including the identification of the terms of the debt host contract and the embedded derivative (see the next section).
Measurement, including the allocation of debt proceeds between the host debt contract and the embedded derivative, and subsequent measurement (see Section 8.5.3).
Embedded derivative reassessment requirements (see Section 8.5.4).
The accounting that applies if an entity is unable to reliably identify and measure an embedded feature that must be accounted for as a derivative (see Section 8.5.5).
The fair value election for hybrid financial instruments (see Section 8.5.6).

8.5.2 Initial Recognition

8.5.2.1 General

ASC 815-10

25-1 An entity shall recognize all of its derivative instruments in its statement of financial position as either assets or liabilities depending on the rights or obligations under the contracts.

If a separated embedded derivative represents a non-option feature (e.g., an embedded forward or swap), its terms are identified in a manner that results in a fair value of zero for the derivative at initial recognition (see the next section). An option-based derivative is separated on the basis of the stated terms of the hybrid instrument, which usually results in the attribution of an initial fair value other than zero to the embedded derivative (see Section 8.5.2.3). If a host contract contains multiple embedded features that require bifurcation, they are separated as one compound embedded derivative (see Section 8.5.2.4). An entity cannot impute terms that are not clearly present in the hybrid instrument (see Section 8.3.2.4).

8.5.2.2 Identification of the Terms of a Non-Option Embedded Derivative

ASC 815-15

30-4 In separating a non-option embedded derivative from the host contract under paragraph 815-15-25-1, the terms of that non-option embedded derivative shall be determined in a manner that results in its fair value generally being equal to zero at the inception of the hybrid instrument. Because a loan and an embedded derivative can be bundled in a structured note that could have almost an infinite variety of stated terms, it is inappropriate to necessarily attribute significance to every one of the note’s stated terms in determining the terms of the non-option embedded derivative. If a non-option embedded derivative has stated terms that are off-market at inception, that amount shall be quantified and allocated to the host contract because it effectively represents a borrowing. (This paragraph does not address the bifurcation of the embedded derivative by a holder who has acquired the hybrid instrument from a third party after the inception of that hybrid instrument.) The non-option embedded derivative shall contain a notional amount and an underlying consistent with the terms of the hybrid instrument. Artificial terms shall not be created to introduce leverage, asymmetry, or some other risk exposure not already present in the hybrid instrument. Generally, the appropriate terms for the non-option embedded derivative will be readily apparent. Often, simply adjusting the referenced forward price (pursuant to documented legal terms) to be at the market for the purpose of separately accounting for the embedded derivative will result in that non-option embedded derivative having a fair value of zero at inception of the hybrid instrument.

Example 12: Separating a Non-Option Embedded Derivative

55-160 This Example illustrates the application of paragraph 815-15-30-4 and assumes that the illustrative non-option embedded derivative is a plain-vanilla forward contract with symmetrical risk exposure and that the hybrid instrument was newly entered into by the parties to the contract. Assume that the hybrid instrument is not a derivative instrument in its entirety.

55-161 Entity A plans to advance Entity X $900 for 1 year at a 6 percent interest rate and concurrently enter into an equity-based derivative instrument in which it will receive any increase or pay any decrease in the current market price ($200) of XYZ Corporation’s common stock. Those two transactions (that is, the loan and the derivative instrument) can be bundled in a structured note that could have almost an infinite variety of terms. The following presents 5 possible contractual terms for the structured note that would be purchased by Entity A for $900:

Note 1: Entity A is entitled to receive at the end of 1 year $954 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $200.
Note 2: Entity A is entitled to receive at the end of 1 year $955 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $201.
Note 3: Entity A is entitled to receive at the end of 1 year $755 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $1.
Note 4: Entity A is entitled to receive at the end of 1 year $1,054 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $300.
Note 5: Entity A is entitled to receive at the end of 1 year $1,060 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation’s common stock over (or under) $306.

55-162 All of these five terms of a structured note will provide the same cash flows, given a specified market price of XYZ Corporation’s common stock. If the market price of XYZ Corporation’s common stock at the end of 1 year is still $200, Entity A will receive $954 under all 5 note terms. If the market price of XYZ Corporation’s common stock at the end of 1 year increases to $306, Entity A will receive $1,060 under all 5 note terms.

55-163 For simplicity in constructing this Example, it is assumed that an equity-based cash-settled forward contract with a strike price equal to the stock’s current market price has a zero fair value. In many circumstances, a zero-value forward contract can have a strike price greater or less than the stock’s current market price.

55-164 The differences in the terms for these five notes are totally arbitrary because those differences have no effect on the ultimate cash flows under the structured note; thus, those differences are nonsubstantive and should have no influence on how the terms of an embedded derivative are identified. Therefore, the separation of the hybrid instrument into an embedded derivative and a host debt instrument should be the same for all five terms described above for the structured note (because they are merely different descriptions of the same ultimate cash flows). That bifurcation would generally result in the structured note being accounted for as a debt host contract with an initial carrying amount of $900 and a fixed annual rate of interest of 6 percent and an embedded forward contract with a $200 forward price, which results in an initial fair value of zero. Instead, if the five notes were bifurcated based on all their contractual terms, such bifurcation would be the equivalent of simply marking an arbitrary portion of a debt instrument to market based on nonsubstantive arbitrary differences in those contractual terms — an inappropriate outcome.

An embedded derivative that does not involve any optionality (i.e., an embedded forward or swap) is separated from the debt host contract in a manner such that its fair value is zero when the debt is first recognized (i.e., it is assumed that the entity received or paid no amount for the embedded feature). All of the proceeds of the hybrid debt instrument are allocated to the debt host contract; none are allocated to the embedded derivative upon initial recognition of the hybrid debt instrument (see Section 8.5.3.1).

Accordingly, the debtor cannot necessarily rely on the stated terms of the embedded feature for separation purposes. If the stated terms imply that the embedded feature would have some fair value at inception, those terms are redefined and calibrated so that the embedded feature instead has zero fair value at inception. For example, a stated forward price might need to be increased or decreased for separation purposes with an equal and offsetting adjustment to the manner in which the terms of the host contract are identified. The purpose of this requirement is to ensure that a debt component in a hybrid financial instrument is not attributed to an embedded derivative. If a non-option embedded derivative were to be separated on terms that result in an initial fair value other than zero (i.e., on “off-market” terms), the amount attributed to the embedded derivative effectively represents a debt element since the off-market element is “repaid” at maturity.

8.5.2.3 Identification of the Terms of an Option-Based Embedded Derivative

ASC 815-15

30-6 The terms of an option-based embedded derivative shall not be adjusted to result in the embedded derivative being at the money at the inception of the hybrid instrument. In separating an option-based embedded derivative from the host contract under paragraph 815-15-25-1, the strike price of the embedded derivative shall be based on the stated terms documented in the hybrid instrument. As a result, the option-based embedded derivative at inception may have a strike price that does not equal the market price of the asset associated with the underlying. The guidance in this paragraph addresses both of the following:

The bifurcation of the option-based embedded derivative by a holder who has acquired the hybrid instrument from a third party either at inception or after inception of that hybrid instrument
The bifurcation of the option-based embedded derivative by the issuer when separate accounting for that embedded derivative is required.

An embedded derivative that involves optionality is separated on the basis of the stated terms of the hybrid instrument (e.g., the strike price specified in the hybrid instrument). Under ASC 815-15-30-6, an entity is not permitted to identify terms of an option-based embedded derivative that are different from those in the hybrid instrument. For example, an entity cannot adjust the manner in which the option is identified so as to achieve an intrinsic option value of zero at inception. Economically, an embedded derivative that involves optionality is different from a non-option embedded derivative because it is possible that the option will never be exercised.

8.5.2.4 Multiple Embedded Derivative Features

ASC 815-15

25-7 If a hybrid instrument contains more than one embedded derivative feature that would individually warrant separate accounting as a derivative instrument under paragraph 815-15-25-1, those embedded derivative features shall be bundled together as a single, compound embedded derivative that shall then be bifurcated and accounted for separately from the host contract under this Subtopic unless a fair value election is made pursuant to paragraph 815-15-25-4.

25-8 An entity shall not separate a compound embedded derivative into components representing different risks (for example, based on the risks discussed in paragraphs 815-20-25-12[f] and 815-20-25-15[i]) and then account for those components separately.

25-9 If a compound embedded derivative comprises multiple embedded derivative features that all involve the same risk exposure (for example, the risk of changes in market interest rates, the creditworthiness of the obligor, or foreign currency exchange rates), but those embedded derivative features differ from one another by including or excluding optionality or by including a different optionality exposure, an entity shall not separate that compound embedded derivative into components that would be accounted for separately.

25-10 If some of the embedded derivative features in a hybrid instrument are clearly and closely related to the economic characteristics and risks of the host contract, those embedded derivative features shall not be included in the compound embedded derivative that is bifurcated from the host contract and separately accounted for.

If a hybrid contract contains more than one embedded feature that requires bifurcation under ASC 815-15-25-1, those embedded derivatives must be bundled together as a single compound embedded derivative. For example, an entity cannot separate multiple embedded derivatives and designate only some as hedging instruments. The compound embedded derivative that is separated should not include embedded features that are evaluated separately and do not qualify for separation (e.g., features that are considered clearly and closely related to the debt host).

8.5.3 Measurement

8.5.3.1 Initial Measurement (Including Allocation)

ASC 815-10

30-1 All derivative instruments shall be measured initially at fair value.

ASC 815-15

30-2 The allocation method that records the embedded derivative at fair value and determines the initial carrying value assigned to the host contract as the difference between the basis of the hybrid instrument and the fair value of the embedded derivative shall be used to determine the carrying values of the host contract component and the embedded derivative component of a hybrid instrument if separate accounting for the embedded derivative is required by this Subtopic. (Note that Section 815-15-25 allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation.)

30-3 The objective is to estimate the fair value of the derivative features separately from the fair value of the nonderivative portions of the contract. Estimates of fair value shall reflect all relevant features of each component. For example, an embedded purchased option that expires if the contract in which it is embedded is prepaid would have a different value than an option whose term is a specified period that is not subject to truncation.

An entity is required to use a “with-and-without” method (see Section 3.4.2.2) to allocate the cost basis between a bifurcated derivative and the host contract. Under this method, (1) a portion of the basis of the hybrid instrument (e.g., debt proceeds allocable to a hybrid debt instrument) equal to the fair value of the derivative component is allocated to the bifurcated derivative and then (2) the remaining carrying amount of the hybrid instrument is allocated to the host contract. Application of this method will not result in recognition of an immediate gain or loss in earnings related to the derivative because the initial carrying amount of the derivative will be its fair value.

Example 8-27

Initial Recognition of Embedded Derivative

Company ABC issues $100 million of 10-year, 4 percent fixed-rate convertible debt in $1,000 denominations. Each $1,000 bond is convertible into 20 common shares of ABC stock. Assume that the conversion option meets the definition of a derivative instrument and must be bifurcated and accounted for separately. At issuance, the fair value of the conversion option is $100 per $1,000 bond or $10 million in aggregate. The issuer would initially recognize the conversion option liability at $10 million and the host debt instrument at $90 million.

At the 2014 AICPA Conference on Current SEC and PCAOB Developments, staff from the SEC’s OCA discussed situations in which entities enter into financing arrangements in which the total net proceeds received for an issued hybrid instrument are less than the fair value of the related financial liabilities that must be measured at fair value (see Section 3.4.3.1). These scenarios can occur if an entity wishes to align itself with a strategic investor or needs financing because of financial difficulties. For example, an entity that wants to align itself with a specific investor may issue $15 million of convertible debt at par and be required to bifurcate an in-the-money conversion option with a fair value of $20 million.

When a reporting entity issues a hybrid instrument and must recognize related financial liabilities (e.g., an embedded derivative that must be bifurcated) at fair values that exceed the total net proceeds received, the entity should perform a detailed analysis of the financing transaction. Its analysis should include:

Verifying that the financial liabilities that must be measured at fair value are appropriately valued under ASC 820.
Determining whether the transaction was conducted at arm’s length and whether the parties involved are related parties under ASC 850.
Evaluating all elements of the transaction to determine whether there are any other rights or privileges received that should be recognized as an asset under other applicable guidance.

If, after performing this analysis, the entity concludes that the amount of financial liabilities measured at fair value still exceeds the total net proceeds received, it should recognize the excess as a loss in earnings. In addition, the entity should disclose the nature of the transaction in the financial statement footnotes, including (1) the reasons why the entity entered into the transaction and (2) the benefits received. If, however, the entity determines that the transaction was not conducted at arm’s length or was executed with a related party, it should consider consulting with the SEC staff or the entity’s accounting advisers before reaching a conclusion about the appropriate accounting treatment.

8.5.3.2 Subsequent Measurement

ASC 815-10

35-1 All derivative instruments shall be measured subsequently at fair value.

When a debtor is required to bifurcate an embedded derivative from a debt instrument, it accounts for the debt host contract under the requirements that apply to such contracts; that is, typically under the interest method in ASC 835-30 (see Section 6.2). The accounting for the debt host contract is based on the contractual cash flows that remain after separation of the cash flows attributable to the embedded derivative. For example, the application of the interest method to the debt host contract depends on the amount of proceeds and subsequent contractual cash flows that are attributed to the debt host contract. The embedded derivative is accounted for at fair value, with changes in fair value recognized in earnings (unless it is designated as a hedging instrument in a qualifying cash flow hedge or net investment hedge under ASC 815, in which case fair value changes are recognized in OCI).

8.5.4 Reassessment

8.5.4.1 General

ASC 815-10

25-2 If a contract that did not meet the definition of a derivative instrument at acquisition by the entity meets the definition of a derivative instrument after acquisition by the entity, the contract shall be recognized immediately as either an asset or liability with the offsetting entry recorded in earnings.

25-3 If a contract ceases to be a derivative instrument pursuant to this Subtopic and an asset or liability had been recorded for that contract, the carrying amount of that contract becomes its cost basis and the entity shall apply other generally accepted accounting principles (GAAP) that are applicable to that contract prospectively from the date that the contract ceased to be a derivative instrument. If the derivative instrument had been designated in a cash flow hedging relationship and a gain or loss is recorded in accumulated other comprehensive income, then the guidance in Sections 815-30-35 and 815-30-40 shall be applied accordingly.

30-3 A contract recognized under paragraph 815-10-25-2 because it meets the definition of a derivative instrument after acquisition by an entity shall be measured initially at its then-current fair value.

ASC 815-40

35-8 The classification of a contract (including freestanding financial instruments and embedded features) shall be reassessed at each balance sheet date. If the classification required under this Subtopic changes as a result of events during the period (if, for example, as a result of voluntary issuances of stock the number of authorized but unissued shares is insufficient to satisfy the maximum number of shares that could be required to net share settle the contract [see discussion in paragraph 815-40-25-20]), the contract shall be reclassified as of the date of the event that caused the reclassification. There is no limit on the number of times a contract may be reclassified.

50-3 Contracts within the scope of this Subtopic may be required to be reclassified into (or out of) equity during the life of the instrument (in whole or in part) pursuant to the provisions of paragraphs 815-40-35-8 through 35-13. An issuer shall disclose contract reclassifications (including partial reclassifications), the reason for the reclassification, and the effect on the issuer’s financial statements.

A debtor should continually reassess whether an embedded feature qualifies as a derivative and, if so, for any derivative scope exception. For example, an entity is required to reassess whether the net settlement characteristic in the definition of a derivative is met (see Section 8.3.4.4.5). If an embedded feature begins or ceases to meet the definition of a derivative or any scope exception, the analysis of whether the feature should be separated and accounted for as a derivative under ASC 815 is affected.

If debt is modified or exchanged and is treated as an extinguishment, the debtor should reperform its analysis of whether any embedded features must be separated from the debt under ASC 815-15. Even if the modification or exchange is not treated as an extinguishment of the original debt for accounting purposes (see Chapter 10), reperformance of the analysis may be necessary because the contractual arrangement has been changed. If separation of an embedded derivative is required after the initial recognition of a debt instrument, the feature is bifurcated and recognized at fair value at the time it begins to meet the bifurcation criteria (see Section 8.3). A portion of the current carrying amount of the debt instrument equal to the current fair value of the feature as of the reclassification date is reallocated to the embedded derivative in a manner consistent with the allocation guidance in ASC 815-15-30-2 (see Section 8.5.3.1).

Conversely, if separation of an embedded feature is no longer required after the initial recognition of a debt instrument, the embedded derivative is recombined with its host contract at its current fair value at the time it ceases to meet the bifurcation criteria. However, special guidance applies to bifurcated equity conversion features (see Section 8.5.4.3).

8.5.4.2 Conversion Feature Ceases to Qualify for the Own Equity Scope Exception

ASC 815-40

35-9 . . . If an embedded feature no longer qualifies for the derivatives scope exception under this Subtopic, the feature shall be separated from its host contract and accounted for as a derivative instrument in accordance with Subtopic 815-10 and Subtopic 815-15 (if all of the criteria in paragraph 815-15-25-1 are met).

If separation of an embedded equity conversion feature is required after the initial recognition of a convertible debt instrument, the feature is bifurcated and recognized at fair value at the time it begins to meet the bifurcation criteria (see Section 8.3). A portion of the current carrying amount of the debt instrument equal to the current fair value of the embedded derivative feature as of the reclassification date is reallocated to the embedded derivative in a manner consistent with the allocation guidance in ASC 815-15-30-2 (see Section 8.5.3.1). The entity also should provide the disclosures required by ASC 815-40-50-3.

8.5.4.3 Conversion Feature Ceases to Be Bifurcated as a Derivative

ASC 815-15

35-4 If an embedded conversion option in a convertible debt instrument no longer meets the bifurcation criteria in this Subtopic, an issuer shall account for the previously bifurcated conversion option by reclassifying the carrying amount of the liability for the conversion option (that is, its fair value on the date of reclassification) to shareholders’ equity. Any debt discount recognized when the conversion option was bifurcated from the convertible debt instrument shall continue to be amortized.

40-1 If a holder exercises a conversion option for which the carrying amount has previously been reclassified to shareholders’ equity pursuant to paragraph 815-15-35-4, the issuer shall recognize any unamortized discount remaining at the date of conversion immediately as interest expense.

40-4 If a convertible debt instrument with a conversion option for which the carrying amount has previously been reclassified to shareholders’ equity pursuant to the guidance in paragraph 815-15-35-4 is extinguished for cash (or other assets) before its stated maturity date, the entity shall do both of the following:

The portion of the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment shall be allocated to equity.
The remaining reacquisition price shall be allocated to the extinguishment of the debt to determine the amount of gain or loss.

50-3 An issuer shall disclose both of the following for the period in which an embedded conversion option previously accounted for as a derivative instrument under this Subtopic no longer meets the separation criteria under this Subtopic:

A description of the principal changes causing the embedded conversion option to no longer require bifurcation under this Subtopic
The amount of the liability for the conversion option reclassified to stockholders’ equity.

ASC 815-40

35-10 . . . An embedded derivative that qualifies for the derivatives scope exception upon reassessment under this Subtopic that was separated from its host contract and accounted for as a derivative instrument in accordance with Subtopic 815-10 shall be reclassified to equity. The previously bifurcated embedded derivative shall not be recombined with its host contract.

If a previously bifurcated embedded conversion option in convertible debt ceases to meet the ASC 815-15 bifurcation criteria, any previously recognized gains and losses should not be reversed. Instead, the carrying amount of the embedded derivative (i.e., the feature’s fair value as of the date of the reclassification) should be reclassified to shareholders’ equity (see Section 6.4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity). The entity also should provide the disclosures required by ASC 815-15-50-3 and ASC 815-40-50-3.

Example 8-28

Convertible Debt With a Conversion Option That No Longer Requires Bifurcation

On January 1, 20X5, Company ABC issues a 10-year note that has a $1,000 par value, accrues interest at an annual rate of 4 percent, and is convertible into 100 shares of ABC common stock. The fair value of one share of ABC’s common stock is $8.50 on the issue date. Upon conversion, ABC must settle the accreted value of the note in cash and has the option to settle the conversion spread in either cash or common stock (commonly referred to as Instrument C). After considering its potential share requirements for other existing commitments, ABC concludes that it cannot assert that it has a sufficient number of authorized but unissued common shares available to share settle the conversion option; accordingly, the conversion option does not qualify for equity classification under ASC 815-40. After applying ASC 815-40 and ASC 815-15-25-1, ABC concludes that the conversion option must be bifurcated and accounted for as a separate derivative.

At inception, on January 1, 20X5, ABC records the entry below to bifurcate the embedded derivative. Assume that the fair value of the conversion option on that date is $50.

As of each quarterly reporting date, ABC determines that continued bifurcation of the conversion option is required. For each quarterly reporting period, the derivative (which is not designated as a hedging instrument) is marked to fair value, with the changes in fair value recognized in earnings. Company ABC also recognizes its contractual interest expense on the note, and the debt discount created by the bifurcation of the embedded conversion option is amortized to interest expense. The following journal entries reflect the cumulative activity booked during the year ended December 31, 20X5 (each journal entry represents the sum of the quarterly journal entries):

As of December 31, 20X5, the carrying amounts of the debt host contract and the conversion liability are $955 and $200, respectively.

On January 1, 20X6, ABC obtains shareholder approval to increase the number of its authorized common shares to a level sufficient for it to assert that it has the ability to share settle the conversion option. On the basis of this approval, ABC concludes that the conversion option now qualifies for equity classification under ASC 815-40 and that the bifurcated derivative liability no longer needs to be accounted for as a separate derivative under ASC 815-15-25-1.

Company ABC believes that no modification of terms occurred. Rather, an event extraneous to the note (obtaining shareholder approval to increase authorized common shares) has caused the embedded conversion option to no longer meet the conditions for bifurcation.

Company ABC records the following entry on January 1, 20X6 (assume no changes in fair values from December 31, 20X5, to January 1, 20X6).

Note that the debt discount will continue to be amortized over the remaining term of the debt since this discount reflects the issuer’s economic borrowing costs related to the convertible debt instrument. Company ABC also would be required to provide the disclosures described in ASC 815-15-50-3 and ASC 815-40-50-3.

8.5.5 Inability to Reliably Identify and Measure Embedded Derivative

8.5.5.1 Recognition and Measurement

ASC 815-15

30-1 An entity shall measure both of the following initially at fair value: . . .

b. An entire hybrid instrument if an entity cannot reliably identify and measure the embedded derivative that paragraph 815-15-25-1 requires be separated from the host contract.

35-2 If an entity cannot reliably identify and measure the embedded derivative that paragraph 815-15-25-1 requires be separated from the host contract, the entire contract shall be measured subsequently at fair value with gain or loss recognized in earnings. Paragraph 815-20-25-71(a)(4) states that the entire contract shall not be designated as a hedging instrument pursuant to Subtopic 815-20.

In the unusual situation in which an entity cannot reliably identify and measure an embedded feature that is required to be separated as a derivative, the entity must record the entire hybrid instrument at fair value and recognize changes in fair value through earnings. In practice, this provision is rarely applied. Under no circumstance can such an instrument be designated as a hedging instrument under ASC 815-20.

8.5.5.2 Presentation

ASC 815-15

45-1 In each statement of financial position presented, an entity shall report hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1 in a manner that separates those reported fair values from the carrying amounts of assets and liabilities subsequently measured using another measurement attribute on the face of the statement of financial position. To accomplish that separate reporting, an entity may do either of the following:

Display separate line items for the fair value and non-fair-value carrying amounts
Present the aggregate of the fair value and non-fair-value amounts and parenthetically disclose the amount of fair value included in the aggregate amount.

If a debtor accounts for debt at fair value because it either cannot reliably identify and measure an embedded derivative (see Section 8.5.5.1) or has applied the fair value option under ASC 815-15 or ASC 825-10 to the debt (see Sections 4.4 and 8.5.6, respectively), it must report the related fair value amounts separately on the face of the balance sheet under ASC 815-15-45-1.

8.5.5.3 Disclosure

ASC 815-15

50-1 For those hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1, an entity shall also disclose the information specified in paragraphs 825-10-50-28 through 50-32.

50-2 An entity shall provide information that will allow users to understand the effect of changes in the fair value of hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1 on earnings (or other performance indicators for entities that do not report earnings).

If a debtor accounts for debt at fair value because it cannot reliably identify and measure an embedded derivative (see Section 8.5.5.1), it must provide the disclosures that are required for financial liabilities for which the fair value option in ASC 825-10 has been elected (see Section 14.4.11).

8.5.6 Fair Value Election for Hybrid Financial Instruments

8.5.6.1 Eligibility

ASC 815-15

25-4 An entity that initially recognizes a hybrid financial instrument that under paragraph 815-15-25-1 would be required to be separated into a host contract and a derivative instrument may irrevocably elect to initially and subsequently measure that hybrid financial instrument in its entirety at fair value (with changes in fair value recognized in earnings and, if paragraph 825-10-45-5 is applicable, other comprehensive income). A financial instrument shall be evaluated to determine that it has an embedded derivative requiring bifurcation before the instrument can become a candidate for the fair value election.

25-5 The fair value election shall be supported by concurrent documentation or a preexisting documented policy for automatic election. That recognized hybrid financial instrument could be an asset or a liability and it could be acquired or issued by the entity. The fair value election is also available when a previously recognized financial instrument is subject to a remeasurement event (new basis event) and the separate recognition of an embedded derivative. The fair value election may be made instrument by instrument. For purposes of this paragraph, a remeasurement event (new basis event) is an event identified in generally accepted accounting principles, other than the recording of a credit loss under Topic 326, or measurement of an impairment loss through earnings under Topic 321 on equity investments, that requires a financial instrument to be remeasured to its fair value at the time of the event but does not require that instrument to be reported at fair value on a continuous basis with the change in fair value recognized in earnings. Examples of remeasurement events are business combinations and significant modifications of debt as defined in Subtopic 470-50.

25-6 The fair value election shall not be applied to the hybrid instruments described in paragraph 825-10-50-8.

Under ASC 815-15-25-1, an entity may be required to bifurcate and separately account for an embedded derivative contained within a hybrid instrument. In lieu of such separation, ASC 815-15-25-4 allows an entity to account for the entire hybrid instrument at fair value, provided that the instrument is a financial asset or financial liability, with changes recognized in earnings and, if applicable, OCI.

The fair value election in ASC 815-15 can be made on an instrument-by-instrument basis, or an entity can elect this option for all qualifying hybrid financial instruments on some other basis, such as an entity-wide policy decision or a type-of-instrument basis. In all scenarios, the fair value election under ASC 815-15 must be supported with appropriate concurrent documentation that eliminates any question regarding whether the entity elected to apply fair value measurement to a particular instrument.

For the following reasons, the fair value election in ASC 815-15 applies to a narrower population (scope) of items than the fair value option in ASC 825-10:

The fair value election in ASC 815-15 applies only to hybrid financial instruments for which bifurcation of an embedded derivative would otherwise be required. An entity that elects the fair value option in ASC 825-10 is not required to determine that an embedded derivative would need to be accounted for separately under ASC 815-15.
ASC 815-15-25-6 prohibits the fair value election for any hybrid instrument that is discussed in ASC 825-10-50-8, which describes 15 items for which public business entities are not required to provide fair value disclosures. The scope of ASC 825-10-50-8 is more restrictive than the scope of the fair value option in ASC 825-10-15-4 and 15-5 (see Section 4.4.2).

Like ASC 825, ASC 815-15 allows the fair value election for an eligible item only upon (1) initial recognition or (2) the occurrence of a subsequent remeasurement event (i.e., a subsequent remeasurement of the entire instrument at fair value under other U.S. GAAP). Therefore, under both ASC 815-15 and ASC 825, an entity is prohibited from making the fair value election upon determining that an embedded derivative that was previously not bifurcated under ASC 815-15 subsequently must be bifurcated (e.g., a hybrid financial instrument containing an embedded derivative that meets the net settlement condition in ASC 815-10-15-83(c) after initial recognition).

There are no situations in which an entity could make the fair value election for a hybrid instrument under ASC 815-15 but would be prohibited from electing the fair value option for the same instrument under ASC 825-10. In addition, regardless of whether the entity applies the fair value accounting guidance in ASC 815-15 or ASC 825, the hybrid financial instrument cannot be designated as a hedging instrument under ASC 815-20. Furthermore, the documentation and disclosure requirements related to the fair value election in ASC 815-15 are the same as those related to the fair value option in ASC 825-10.

Since the fair value election under ASC 815-15 applies to a narrower population of items than does the fair value option under ASC 825, entities can effectively disregard the fair value election guidance in ASC 815-15-25-4. While ASC 815-15 requires an entity to first determine that a hybrid financial instrument contains an embedded derivative for which bifurcation would otherwise be required under ASC 815-15, the entity can bypass this assessment because — regardless of whether such bifurcation is required — the hybrid financial instruments that are eligible for the fair value election in ASC 815-15 are also eligible for the fair value option in ASC 825-10 (and the fair value option in ASC 825 can be elected regardless of whether an entity has identified an embedded derivative for which bifurcation would otherwise be required). Furthermore, the disclosure requirements applicable to a hybrid financial instrument for which the fair value election is made under ASC 815-15 are consistent with those in ASC 825-10 (see Section 14.4.11). Irrespective of whether it elects fair value accounting under ASC 815-15 or ASC 825-10, an entity is subject to the applicable incremental disclosure requirements for (1) derivatives in ASC 815 and (2) items for which the fair value option has been elected in ASC 825-10. We believe that the guidance on fair value elections in ASC 815-15 was retained in U.S. GAAP because that guidance was available (and may have been used) before the fair value option in ASC 825-10 became effective. Thus, entities may still have hybrid financial instruments that are being recognized at fair value in their entirety in accordance with ASC 815-15 because those instruments were issued before the effective date of the fair value option guidance in ASC 825-10.

8.5.6.2 Measurement

ASC 815-15

30-1 An entity shall measure both of the following initially at fair value:

A hybrid financial instrument that under paragraph 815-15-25-1 would be required to be separated into a host contract and a derivative instrument that an entity irrevocably elects to initially and subsequently measure in its entirety at fair value (with changes in fair value recognized in earnings) . . .

35-1 If an entity irrevocably elected to initially and subsequently measure a hybrid financial instrument in its entirety at fair value, changes in fair value for that hybrid financial instrument shall be recognized in earnings. Paragraph 815-20-25-71(a)(3) states that the entire contract shall not be designated as a hedging instrument pursuant to Subtopic 815-20.

If an entity elects the fair value option in ASC 815-15 for a hybrid financial instrument, no embedded feature should be separated as a derivative (see Section 8.3.3). The accounting for the hybrid financial instrument is the same as if the fair value option in ASC 825-10 had been applied (see Section 6.3).

8.5.6.3 Presentation

ASC 815-15

Display separate line items for the fair value and non-fair-value carrying amounts
Present the aggregate of the fair value and non-fair-value amounts and parenthetically disclose the amount of fair value included in the aggregate amount.

45-2 If an entity has designated a financial liability under the fair value election in accordance with paragraphs 815-15-25-4 through 25-6, the entity shall apply the guidance in paragraph 825-10-45-5 on the presentation of changes in the liability’s fair value that result from changes in instrument-specific credit risk.

If a debtor accounts for debt at fair value because it either (1) has applied the fair value option in ASC 815-15 or ASC 825-10 to the debt or (2) cannot reliably identify and measure an embedded derivative that must be separated (see Section 8.5.5), it must report the related fair value amounts separately on the face of the balance sheet under ASC 815-15-25-45-1. The requirements in ASC 825-10 related to the presentation of changes in a liability’s fair value that result from changes in instrument-specific credit risk (see Section 6.3.2) apply also to financial liabilities for which the fair value option in ASC 815-15 has been applied.

8.5.6.4 Disclosure

ASC 815-15

If a debtor elects the fair value option in ASC 815-15, it must provide the disclosures that are required for financial liabilities for which the fair value option in ASC 825-10 has been elected (see Section 14.4.11).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.