Appendix A — Embedded Derivative Analysis

A.3 Bifurcation Analysis for Embedded Conversion Features

The guidance in this section applies to an issuer’s accounting for convertible debt instruments. It does not apply to nonconvertible debt (or mandatorily redeemable preferred stock) issued with detachable warrants or to share-settled redemption or indexation features (see Section 2.4).

To determine whether the embedded conversion option in a convertible debt instrument must be separated as an embedded derivative under ASC 815, the issuer should analyze the instrument under ASC 815-15-25-1.

A.3.1 Analysis Under the Guidance in ASC 815-15-25-1

A conversion option needs to be accounted for separately if all three conditions in ASC 815-15-25-1 are satisfied. Convertible debt issued in the form of debt consists of a debt host and an embedded conversion option; however, in unusual situations, convertible debt instruments issued in the form of a share may be considered to contain equity hosts. For an instrument issued in the form of a share, an analysis of the stated and implied substantive terms is always required (see Section A.2). Given the complexity of determining the nature of a host contract for a convertible instrument issued in the form of a share, entities are encouraged to consult with their accounting advisers. If entities conclude that the host is more akin to equity under ASC 815-15-25-16 and related guidance, the conversion option would be considered clearly and closely related to the host and would thus fail to meet the bifurcation criterion in ASC 815-15-25-1(a); no further analysis would be required.

The table below illustrates an analysis under ASC 815-15-25-1. In this analysis, the host instrument is considered a debt host and the issuer is not measuring the convertible debt instrument at fair value, with changes in fair value recorded in earnings. If the convertible debt instrument were being measured at fair value, with changes in fair value recorded in earnings (e.g., if the issuer elected to apply the fair value option to convertible debt that qualifies for the fair value option), the issuer would not bifurcate any embedded derivatives because the criterion in ASC 815-15-25-1(b) would not be met.

Condition	Is the Condition Met?
ASC 815-15-25-1(a) — “The economic characteristics and risks of the embedded derivative [instrument] are not clearly and closely related to the economic characteristics and risks of the host contract.”	Yes. An equity conversion option is not clearly and closely related to a debt host (see ASC 815-15-25-51).
ASC 815-15-25-1(b) — The contract (“the hybrid instrument”) that embodies both the embedded derivative instrument and the host contract “is not remeasured at fair value under otherwise applicable [GAAP] with changes in fair value reported in earnings as they occur.”	Yes. The issuer does not elect to measure the convertible debt instrument at fair value through earnings. Note that ASC 825-10-15-5(f) precludes application of the fair value option to convertible debt instruments that contain a component that requires separate recognition within equity upon issuance.
ASC 815-15-25-1(c) — “A separate instrument with the same terms as the embedded derivative would . . . be a derivative instrument subject to the requirements of [ASC 815]. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)”	Maybe. Whether the conversion option in a convertible debt or redeemable preferred stock instrument will meet the definition of a derivative that would be subject to the requirements of ASC 815 on a stand-alone basis primarily depends on whether the option may be net settled. If the option may be net settled (see table below for a definition) and does not qualify for the ASC 815-10-15-74(a) scope exception, this condition may be met. See further discussion below.

If any of the three above conditions is not met, no further analysis is necessary (i.e., the conversion option is not required to be separated as an embedded derivative). However, the conditions in ASC 815-15-25-1(a) and (b) will usually be met for convertible debt instruments, and an entity will need to perform further analysis to determine whether the condition in ASC 815-15-25-1(c) has been satisfied.

A.3.2 Is the Condition in ASC 815-15-25-1(c) Satisfied (i.e., if the Option Was Freestanding, Would It Meet the Definition of a Derivative)?

The following table presents an analysis of whether a typical conversion option meets the definition of a derivative in ASC 815-10-15-83:

Characteristics of a Derivative	Characteristic Present?
ASC 815-10-15-83(a)(1) — “One or more underlyings.”	Yes. One underlying is the price of the shares that the instrument may be converted into.
ASC 815-10-15-83(b) — It “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.”	Yes. As noted in ASC 815-15-25-1(c), the initial investment in the hybrid instrument should not be considered the initial net investment for the embedded derivative. The initial investment in the embedded derivative typically would be considered approximately equal to the fair value of the conversion option. This amount would typically be smaller, by more than a nominal amount, than the amount that would be required to acquire the shares underlying the conversion option.
ASC 815-10-15-83(c) — “Its terms implicitly or explicitly require or permit net settlement,” it “can readily be settled net by a means outside the contract,” or it “provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.”	Maybe. This characteristic would be met if either of the following occurs: The conversion option may be explicitly net settled at the option of either party. This would be the case if, under any scenario, the holder could receive cash or shares equal to the value of the conversion option without taking delivery of the full number of shares underlying the conversion option. The stock that the holder would receive upon conversion is publicly traded, and the number of shares that the holder would receive could be rapidly absorbed by the market without significantly affecting the price (see ASC 815-10-15-136).

In evaluating whether the conversion option can be explicitly net settled, the entity should consider all of the convertible debt instrument’s terms (e.g., redemption, liquidation features). Sometimes, the conversion option stipulates that, upon conversion, the issuer or the investor may choose to have the instrument settle in 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. In such cases, the terms of the conversion option explicitly provide for net settlement of the conversion option.

In other cases, the instrument may be redeemable by the holder and, upon redemption, the holder receives 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 the embedded conversion option). The conversion option, by its terms, may only be settled physically. In this case, however, the redemption feature permits the net cash settlement of the conversion option. See Section A.1 for additional guidance on evaluating convertible debt instruments with multiple embedded features.

If the conversion option meets the definition of a derivative on a stand-alone basis, it may still qualify for the scope exception in ASC 815-10-15-74(a) that applies to the issuer of the convertible debt instrument.

A.3.3 Applicability of the ASC 815-10-15-74(a) Scope Exception

ASC 815-10-15-74(a) provides a scope exception for contracts issued or held by a reporting entity that are both (1) indexed to the entity’s own stock and (2) classified in stockholders’ equity in the entity’s statement of financial position.

A.3.3.1 Indexed to the Entity’s Own Stock

ASC 815-40-15-5 through 15-8 provide guidance on whether an instrument or embedded feature is considered indexed to an entity’s own stock (see Chapter 4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity for an in-depth discussion of this guidance). This guidance states that any instrument that is potentially settled in an entity’s own stock and includes a contingency (i.e., a provision that entitles the entity (or the counterparty) to exercise the financial instrument on the basis of changes in an underlying, including the occurrence (or nonoccurrence) of a specified event), is potentially considered indexed to the entity’s own stock (i.e., it is not precluded from classification as equity) as long as the exercise contingency is not based on (1) an observable market, other than the market for the issuer’s stock (if applicable) or (2) an observable index, other than an index calculated or measured solely by reference to the issuer’s own operations (e.g., the issuer’s sales revenue).

In addition to performing the contingency test in ASC 815-40-15-7A and 15-7B, the entity also must assess whether the instrument’s settlement features meet the criteria in ASC 815-40-15-7C through 15-7I for the instrument to be deemed indexed to the entity’s own stock. An equity-linked instrument is considered indexed to the entity’s own stock if either of the following two conditions is met:

The instrument is a “fixed-for-fixed” forward or option on equity shares.
The instrument is not fixed for fixed, but the only variables that could affect the instrument’s settlement amount are inputs used in the pricing (fair value measurement) of a fixed-for-fixed forward or option on equity shares.

A.3.3.2 Classified in Stockholders’ Equity

If the entity can conclude that the instrument is indexed to the issuer’s stock, it must then apply the guidance in ASC 815-40-25 to determine whether the instrument would be classified in stockholders’ equity or as an asset or liability (see Chapter 5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity for an in-depth discussion of this guidance). ASC 815-40-25 provides guidance on financial instruments that are settleable in an entity’s own stock and includes a model that an entity should use to determine the appropriate balance sheet classification of the instruments. Generally, if the instrument can only be settled by physical delivery of shares, it would meet the criteria to be classified as equity under ASC 815-40 (thus qualifying for the ASC 815-10-15-74(a) scope exception). In addition, if the issuer has the right to choose between multiple settlement methods and one of those methods is physical settlement (i.e., delivery of the full amount of shares under the conversion option) or net share settlement, the instrument could meet the criteria to be classified as equity under ASC 815-40. Note that the issuer is required to perform an evaluation in accordance with ASC 815-40-25-7 through 25-35 and ASC 815-40-55-2 through 55-6 in determining whether the conversion feature would be classified as equity unless the instrument is considered a conventional 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 issuer’s discretion). (See ASC 815-40-25-39 through 25-42 and Section 5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity for guidance on determining whether a security is considered a conventional convertible security.) However, if the investor can require the issuer to settle the instrument in net cash (e.g., the investor can choose between net cash and physical settlement), the instrument would not meet the criteria to be classified as equity under ASC 815-40 and therefore would not qualify for the scope exception in ASC 815-10-15-74(a). See further discussion in Section A.4.

If the embedded conversion option is considered a derivative within the scope of ASC 815 and the other two bifurcation conditions described above are met, the issuer would be required to account for it separately. The host contract would be accounted for under otherwise-applicable U.S. GAAP. The embedded conversion option typically would not qualify as a hedging instrument for the issuer because entities are prohibited from hedging their own equity transactions (except in limited circumstances; see ASC 815-20-55-33 regarding an entity’s ability to designate a nonvested stock-appreciation-right obligation as a hedged item).

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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.