Appendix A — Embedded Derivative Analysis

A.2 Determining the Host Contract in a Hybrid Instrument Issued in the Form of a Share

A convertible instrument issued in the legal form of debt is considered to contain a debt host contract.

In accordance with ASC 815-15-25-1(a) and ASC 815-15-25-17A, the determination of whether the host contract of a liability-classified convertible debt instrument issued in the form of a share is more akin to debt or equity depends on the nature of the hybrid instrument’s economic characteristics and risks in accordance with ASC 815-15-25-17A through 25-17D.

ASC 815-15-25-17A includes the following guidance:

For a hybrid financial instrument issued in the form of a share, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, weighing each term and feature on the basis of the relevant facts and circumstances. That is, in determining the nature of the host contract, an entity shall consider the economic characteristics and risks of the entire hybrid financial instrument including the embedded derivative feature that is being evaluated for potential bifurcation. [Emphasis added]

Under this approach, commonly referred to as the “whole-instrument approach,” the nature of the host contract is the same for each embedded feature.

To determine the nature of the host contract under the whole-instrument approach, an entity performs the following steps (see ASC 815-15-25-17C):

Identify all of the hybrid financial instrument’s “stated and implied substantive terms and features” (emphasis added).
Determine whether the identified terms and features are more debt- or equity-like.
Identify the relative weight of the identified terms and features “on the basis of the relevant facts and circumstances.”
Reach a conclusion about the nature of the host contract.

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

The sections below elaborate on these steps.

A.2.1 Identify the Hybrid Instrument’s Substantive Terms and Features

The first step in applying the whole-instrument approach is to identify all of the substantive terms and features of the hybrid financial instrument, whether stated or implied. Common terms and features in a convertible instrument issued in the form of a share include:

Redemption rights.
Conversion rights.
Voting rights.
Dividend rights.
Protective covenants.

A.2.2 Determine Whether the Identified Terms and Features Are More Debt- or Equity-Like

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

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

The following chart illustrates which characteristics are generally more equity-like or debt-like: Image cannot be displayed

For more information, see the other provisions of ASC 815-15-25-17D.

A.2.3 Weigh the Identified Terms and Features

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

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

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

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

A.2.4 Reach a Conclusion About the Nature of the Host Contract

The final step of the whole-instrument approach is to reach a conclusion regarding the nature of the host contract on the basis of the results of the analyses performed in steps 1–3. As explained in ASC 815-15-25-17A, “[i]n evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature does not necessarily determine the economic characteristics and risks of the host contract. Although an individual term or feature may weigh more heavily in the evaluation on the basis of the facts and circumstances, an entity should use judgment based on an evaluation of all of the relevant terms and features.” To further emphasize this point, the guidance in ASC 815-15-25-17A states by way of example that “an entity shall not presume that the presence of a fixed-price, noncontingent redemption option held by the investor in a convertible preferred stock contract, in and of itself, determines whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument.” If a reporting entity is still unclear about the nature of the host contract after performing this analysis, it should consider the expected outcome of the hybrid financial instrument in reaching its final conclusion.

Given the complexity of determining the nature of a host contract of a hybrid instrument with both conversion and redemption features, entities are encouraged to consult with their accounting advisers.

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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.