Appendix A — Embedded Derivative Analysis

A.4 Conversion Option May Be Net Cash Settled Upon Contingent Event

If the investor in a convertible debt instrument (with a debt host contract) can net cash settle the embedded conversion option solely upon the passage of time, the option would not be classified in equity if it were a freestanding instrument. In such a case, if the option also met the bifurcation conditions in ASC 815-15-25-1(a) and (b), it would be a derivative that required bifurcation under ASC 815. However, if the investor’s ability to net cash settle the conversion option is contingent on an event other than the passage of time and that event is outside the issuer’s control, further analysis would be required, especially under ASC 815-40-25.

A.4.1 Overview

As noted in Section A.3, if the conditions in ASC 815-15-25-1(a) and (b) are satisfied, the issuer would be required to bifurcate a conversion option that may be net settled unless the conversion option is considered indexed to the entity’s own stock and would qualify for equity classification on a stand-alone basis. ASC 815-40-25 provides general accounting guidance on the classification of derivatives indexed to a company’s own stock (ASC 815-40-15-5 through 15-8 provide guidance on determining whether an equity-linked financial instrument (or embedded feature) is indexed to an entity’s own stock). Generally, if the investor has the right to require the option to be settled in net cash, the conversion option would not meet the criteria to be classified in equity under ASC 815-40-25.

Sometimes, the investor’s right to require the issuer to settle the conversion option in cash is exercisable only upon the occurrence of a contingent event (the passage of time is not considered a contingent event). Generally, if a derivative indexed to an entity’s own stock can be net cash settled at the option of the investor only upon the occurrence of the contingent event, and that contingent event is not within the issuer’s control, the option would also not meet the criteria for equity classification under ASC 815-40-25.

A.4.1.1 Impact of ASC 815-40-25’s Detailed Provisions

As noted in ASC 815-40-25-39, some provisions of ASC 815-40-25 do not apply to certain embedded derivatives, such as nonseparable conversion options in “conventional” convertible debt (the same model should be applied to liability-classified convertible preferred stock that is similar to conventional convertible debt; however, convertible preferred stock without a mandatory redemption date would not qualify for the exception in ASC 815-40-25-39 (see ASC 815-40-25-42)).

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 25-35 and 815-40-55-2 through 55-6 do not apply if the hybrid contract is 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 discretion of the issuer).

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 be considered conventional for purposes of applying this Subtopic. Standard antidilution provisions contained in an instrument do not preclude a conclusion that the instrument is convertible into a fixed number of shares.

If the terms of a conventional convertible debt instrument allow the investor to select net cash settlement only under certain contingent circumstances, the provisions of ASC 815-40-25 that would otherwise disqualify a conversion option from being classified as equity do not apply and the embedded derivative does not need to be accounted for separately under ASC 815-15-25-1. (See ASC 815-40-25-39 through 25-42 to determine whether the security is considered a conventional convertible instrument.)

The ability of a conversion option in conventional convertible debt to meet the criteria for equity classification is generally unaffected (and thus the option would be excluded from the scope of ASC 815-15-25-1 on the basis of the ASC 815-10-15-74(a) scope exception) if (1) the issuer has first concluded that the conversion option is indexed to its own stock and (2) net cash settlement can only occur under one or more of the following circumstances that may be outside the issuer’s control (specifically, the provisions in ASC 815-40-25-7 through 25-35 and ASC 815-40-55-2 through 55-6):

Settlement of the contract only by delivery of registered shares (if registered shares are unavailable, then settlement of the contract is net cash).
The issuer’s inability to make timely filings with the SEC.
Cash-settled top-off or make-whole provisions.
Change in control (generally).
Bankruptcy.

However, an embedded conversion option in conventional convertible debt would not qualify for equity classification and would require bifurcation if it can be net cash settled (1) upon the occurrence of an event not discussed in ASC 815-40-25-7 through 25-35 or ASC 815-40-55-2 through 55-6 or (2) only upon the passage of time. Also, an embedded conversion option in a convertible debt instrument that is not considered a conventional convertible instrument would not qualify for equity classification and would require bifurcation if it could be net cash settled by the investor under any circumstances that are outside the issuer’s control (including those events discussed in ASC 815-40-25-7 through 25-35 and ASC 815-40-55-2 through 55-6; in certain limited circumstances described in ASC 815-40-25-7 through 25-9, however, net cash settlement would not necessarily preclude equity classification).

The table below summarizes the interaction of these provisions:

	Is Bifurcation Required?
Investor Can Require Net Cash Settlement:1	Instrument Is a Conventional Convertible	Instrument Is Not a Conventional Convertible
Upon the mere passage of time	Yes	Yes
Only under the conditions described in ASC 815-40-25-7 through 25-35 and ASC 815-40-55-2 through 55-6	No	Yes
Under conditions other than those described in ASC 815-40-25-7 through 25-35 and ASC 815-40-55-2 through 55-6	Yes	Yes

Footnotes

In certain limited circumstances described in ASC 815-40-25-7 through 25-9, net cash settlement would not necessarily preclude equity classification.

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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.