A.1 Overview of Bifurcation Analysis for Embedded Features in Convertible Debt Instruments
ASC 815-15
25-1 An embedded derivative
shall be separated from the host contract and
accounted for as a derivative instrument pursuant
to Subtopic 815-10 if and only if all of the
following criteria are met:
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The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
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The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
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A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
The following six-step decision sequence illustrates how to apply this guidance
in the evaluation of whether any embedded derivative features require bifurcation from a
convertible debt instrument:
A.1.1 Step 1 — Determine Whether the Hybrid Contract Is Remeasured at Fair Value Under Other Applicable GAAP, With Changes in Fair Value Recognized in Earnings as They Occur
If the hybrid contract is remeasured at fair value, with changes in fair value recognized in earnings, no embedded feature should be bifurcated (see ASC 815-15-25-1(b)) and further analysis under steps 2–6 is not required. If the hybrid contract is not remeasured at fair value, with changes in fair value recognized in earnings, step 2 should be applied.
Note that ASC 815 and ASC 825 prohibit election of the fair value option for a
convertible debt instrument with an equity component that is
required to be separately recognized upon original
recognition (see Section 2.5). The
guidance in ASC 825-10-15-5(f) specifically states that the
fair value option may not be applied to “[f]inancial
instruments that are, in whole or in part, classified by the
issuer as a component of shareholders’ equity (including
temporary equity) (for example, a convertible debt
instrument within the scope of the Cash Conversion
Subsections of Subtopic 470-20 or a convertible debt
security with a noncontingent beneficial conversion
feature).” Thus, an entity cannot elect the fair value
option if a convertible debt instrument (1) is subject to
the Cash Conversion subsections of ASC 470-20 (see Chapter
6), (2) contains a noncontingent BCF (see
Chapter 7), or (3) was issued at a
substantial premium to par (see Chapter 5).
A.1.2 Step 2 — Determine the Nature of the Host Contract
To determine the nature of the host contract, an entity first considers the form in which the hybrid instrument was issued. If the instrument was issued in the legal form of debt, the host contract is a debt instrument. If it was issued in the legal form of a share (see Section 6.2.2), the entity must consider the contract’s economic characteristics and risks to assess the nature of the host contract. To determine the economic characteristics and risks of such a host contract, an entity must consider all stated and implied substantive terms and features of the hybrid financial instrument. Neither its form (i.e., issued in the form of a share) nor its classification as a liability dictates that the host contract is a debt instrument, although the host contract almost always represents a debt instrument if it is classified as a liability.
If a liability-classified convertible instrument is issued in the form of a share, the reporting entity must apply the “whole-instrument” approach in determining the nature of the host contract. Under that approach, the entity determines the nature of the host contract by considering all the stated and implied substantive terms and features of the hybrid financial instrument, including the embedded feature that is being analyzed for bifurcation. Accordingly, the nature of the host contract is the same for each embedded feature. Further, ASC 815-15-25-17A indicates that when an entity evaluates “the stated and implied substantive terms and features [of the host contract], the existence or omission of any single term or feature does not necessarily determine the economic characteristics and risks of the host contract. Although an individual term or feature may weigh more heavily in the evaluation on the basis of the facts and circumstances, an entity should use judgment based on an evaluation of all of the relevant terms and features.”
For additional information about determining the host contract in a convertible debt instrument issued in the form of a share, see Section A.2.
A.1.3 Step 3 — Identify Each Embedded Feature
A reporting entity identifies the terms of each embedded feature on the basis of the feature’s economic payoff profile rather than on the basis of how it has been formally documented. In identifying the embedded features, the entity should consider all of the convertible instrument’s terms.
Although the guidance in U.S. GAAP does not explicitly address how to determine the unit of accounting for embedded features in a hybrid instrument, the payoff profile approach is commonly applied. Under that approach, each embedded derivative feature in a hybrid instrument is identified on the basis of the monetary or economic value that the feature conveys to the instrument’s counterparty upon settlement and not based solely on how the feature is described in the convertible instrument agreement. This approach is consistent with the definition of an embedded derivative in ASC 815-15-20, which focuses on how an implicit or explicit term affects the cash flows or values of other exchanges required by a contract. ASC 815-15-20 defines an embedded derivative as “[i]mplicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument.”
Under the payoff profile approach, if a feature described in a convertible instrument agreement as a “redemption option” allows the holder to put the security to the issuer for cash equal to the greater of the face value of the security or the fair value of the underlying common stock, the instrument would be considered to contain the following two embedded derivative features: (1) a fixed-price redemption feature and (2) a cash-settled conversion feature. The redemption feature and the conversion feature must be analyzed separately under ASC 815-15-25-1.
A.1.4 Step 4 — Determine Whether the Economic Characteristics and Risks of Each Embedded Feature Are Clearly and Closely Related to Its Host Contract
Once the reporting entity has assessed the nature of the host contract, it should, in accordance with ASC 815-15-25-1(a), evaluate each embedded feature separately to determine whether its economic characteristics and risks are clearly and closely related to those of the host contract. If so, the embedded feature should not be bifurcated. If not, the reporting entity must perform further analysis to determine whether bifurcation of the embedded feature is required, as discussed in steps 5 and 6 below.
The next sections discuss how an entity assesses whether embedded redemption and conversion features are clearly and closely related to the debt host contract in convertible debt instruments that are hybrid instruments containing a debt host (which will nearly always be the case for convertible instruments classified as liabilities). They also discuss the unusual circumstance in which the host is an equity instrument.
A.1.4.1 Redemption Feature
To determine whether a redemption feature is clearly and closely related to the debt host contract, an entity would have to consider ASC 815-15-25-26 and ASC 815-15-25-40 through 25-43 (see further discussion in Sections A.5 and A.6). A redemption feature that is clearly and closely related to the host would not be bifurcated. If the feature is not clearly and closely related to the host, further analysis is required, as discussed in steps 5 and 6 below.
A redemption feature is not considered clearly and closely related to an equity host under ASC 815-15-25-20, which states, in part:
A put option that enables the holder to require the issuer of an equity instrument (which has been deemed to contain an equity host contract in accordance with paragraphs 815-15-25-17A through 25-17D) to reacquire that equity instrument for cash or other assets is not clearly and closely related to that equity instrument. . . . [T]he embedded written call option would not be considered to be clearly and closely related to the equity instrument.
A.1.4.2 Conversion Feature
ASC 815-15-25-51 states that “[t]he changes in fair value of an equity interest and the interest rates on a debt instrument are not clearly and closely related” and that, as a result, conversion options are not clearly and closely related to debt hosts. Therefore, the entity should consider the conversion feature not to be clearly and closely related to a debt host under ASC 815-15-25-1(a), and it should perform further analysis under steps 5 and 6 to determine whether the conversion feature requires bifurcation. See further discussion below and in Sections A.3 and A.4.
A conversion feature is generally considered clearly and closely related to an equity host under ASC 815-15-25-16, which states that “[i]f the host contract encompasses a residual interest in an entity, then its economic characteristics and risks shall be considered that of an equity instrument and an embedded derivative would need to possess principally equity characteristics (related to the same entity) to be considered clearly and closely related to the host contract.”
A.1.4.3 Interest Rate and Other Contingent Payment Features
The determination of whether interest rate-related or other contingent payment
arrangements are clearly and closely related to a
convertible debt instrument that contains a debt
host contract should be based on the facts and
circumstances. (See Sections A.6 and
A.7 for discussion of contingent
payments that are determined to be based on an
interest rate-related underlying. See Section
A.8 for discussion of whether
contingent payments that are not determined to be
based on an interest rate-related underlying
represent credit-sensitive payments.) Contingent
payment arrangements that (1) do not represent
interest rate-related underlyings, (2) are not
credit-sensitive payments, and (3) do not represent
inflation-indexed interest payments under
ASC 815-15-25-50 are generally not considered
clearly and closely related to a debt host contract.
For example, contingent payments that represent
commodity-indexed or equity-indexed payments are not
considered clearly and closely related to a debt
host contract under ASC 815-15-25-48 and 25-49.
ASC 815-15
Commodity-Indexed Interest or
Principal Payments
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.
Equity-Indexed Interest
Payments
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.
A.1.4.4 Term Extension Features
The determination of whether a term-extension feature is clearly and closely related to a convertible debt instrument that contains a debt host requires evaluation under ASC 815-15-25-44 and 25-45:
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.
25-45 The preceding paragraph does not provide guidance for determining whether term-extending options in nondebt host contracts are clearly and closely related to the host contract, as discussed in paragraph 815-15-25-1(a). A term-extending option in a nondebt host contract can have a significantly different effect than a term-extending option in a debt host contract. Nondebt contracts (as well as debt contracts) that contain embedded term-extension features shall be evaluated under paragraph 815-15-25-1 to determine whether the term-extension feature is a derivative instrument that shall be accounted for separately.
Because the market interest rate for the extended term of a convertible debt instrument will be affected by the embedded conversion feature, an entity must use significant judgment in applying this guidance to a convertible debt instrument.
A.1.5 Step 5 — Determine Whether the Embedded Feature, on a Freestanding Basis, Meets the Definition of a Derivative in ASC 815-10-15-83
To be bifurcated, an embedded feature in a hybrid instrument must, on a
freestanding basis, meet the definition of a derivative in
ASC 815-10-15-83:
ASC 815-10
15-83 A
derivative instrument is a financial instrument or
other contract with all of the following
characteristics:
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Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
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One or more underlyings
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One or more notional amounts or payment provisions or both.
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Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
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Net settlement. The contract can be settled net by any of the following means:
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Its terms implicitly or explicitly require or permit net settlement.
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It can readily be settled net by a means outside the contract.
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It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
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Often, the determination of whether the definition of a derivative is met focuses on the definition’s third component — the net settlement characteristic. Usually, an embedded feature in a hybrid financial instrument satisfies the other two components of the definition of a derivative (i.e., (1) underlyings and notional amounts or payment provisions and (2) no or little initial net investment).
If the nature of the host contract is a debt host, which is almost always the case for a convertible instrument classified as a liability, an embedded redemption feature will satisfy the net settlement characteristic in the definition of a derivative (see ASC 815-10-15-107 through 15-109). If, however, the nature of the host contract is an equity host, whether the redemption feature satisfies the net settlement characteristic in the definition of a derivative generally depends on whether the hybrid contract is publicly traded and readily convertible to cash.
In addition, for a host contract whose nature is that of a debt host, a conversion feature will satisfy the net settlement characteristic if the issuer is a public company or the conversion option can be settled net in cash or net in shares. In determining whether the net settlement characteristic has been met, the reporting entity should also consider particular elements of the conversion feature, such as resale restrictions or the number of shares that will be received upon exercise and the impact of other embedded features. If the nature of the host contract is an equity instrument, this evaluation is typically unnecessary because the conversion feature is considered clearly and closely related to the host contract.
Interest rate-related or other contingent payment arrangements that are settled in cash will generally meet the definition of a derivative instrument. The same is usually true if the contingent payments are settled in a variable number of equity shares, even if they are not readily convertible to cash, because settlement of the derivative instrument involves delivery of an asset that is not associated with the underlying.
If the embedded feature meets all components of the definition of a derivative, step 6 should be applied. If not, no further analysis is required and the embedded feature should not be bifurcated.
A.1.6 Step 6 — Determine Whether the Embedded Feature Qualifies for any Scope Exception in ASC 815-10-15
If an embedded feature that is not clearly and closely related to the host contract meets the definition of a derivative on a freestanding basis, the entity should consider whether the feature meets any scope exceptions in ASC 815-10-15.
The issuer of a convertible debt instrument should evaluate whether the embedded conversion feature meets the scope exception in ASC 815-10-15-74(a) for contracts that are both (1) indexed to the issuer’s own stock and (2) classified in stockholders’ equity. This evaluation usually involves an analysis of the embedded feature under ASC 815-40. The investor cannot qualify for the scope exception in ASC 815-10-15-74(a). See further discussion in Sections A.3 and A.4.
A contingent interest rate or other payment arrangement may meet the exception in ASC 815-10-15-82 for registration payment arrangements.
A term-extension feature may meet the exception in ASC 815-10-15-69 through 15-71 for loan commitments.
If the embedded feature does not qualify for a scope exception, it should be bifurcated. If multiple embedded features must be bifurcated under ASC 815, they should not be accounted for as separate derivative instruments but rather as a single compound derivative instrument.