A.5 Bifurcation Analysis for Put and Call Options in Debt Host Contracts
ASC 815-15-25-41 and 25-42 address whether call or put options that can accelerate the settlement of a debt instrument are clearly and closely related to the debt host contract. If an embedded feature represents a put or a call option that can accelerate the settlement of a convertible debt instrument (including a stock-settled redemption feature), an entity must apply ASC 815-15-25-41 and 25-42 to determine whether the option would be considered clearly and closely related to the debt host contract.
ASC 815-15
25-41 Call (put) options that do
not accelerate the repayment of principal on a debt
instrument but instead require a cash settlement that is
equal to the price of the option at the date of exercise
would not be considered to be clearly and closely related to
the debt instrument in which it is embedded.
25-42 The following four-step
decision sequence shall be followed in determining whether
call (put) options that can accelerate the settlement of
debt instruments shall be considered to be clearly and
closely related to the debt host contract:
Step 1: Is the amount paid upon settlement (also
referred to as the payoff) adjusted based on changes
in an index? If yes, continue to Step 2. If no,
continue to Step 3.
Step 2: Is the payoff indexed to an underlying
other than interest rates or credit risk? If yes,
then that embedded feature is not clearly and
closely related to the debt host contract and
further analysis under Steps 3 and 4 is not
required. If no, then that embedded feature shall be
analyzed further under Steps 3 and 4.
Step 3: Does the debt involve a substantial premium
or discount? If yes, continue to Step 4. If no,
further analysis of the contract under paragraph
815-15-25-26 is required, if applicable.
Step 4: Does a contingently exercisable call (put)
option accelerate the repayment of the contractual
principal amount? If yes, the call (put) option is
not clearly and closely related to the debt
instrument. If not contingently exercisable, further
analysis of the contract under paragraph
815-15-25-26 is required, if applicable.
The following chart shows the four-step decision sequence under ASC 815-15-25-42
for determining whether an option would be considered clearly and closely related to
the debt host contract. 
In practice, a discount or premium that is 10 percent or more is considered
“substantial” in the step 3 analysis. In determining whether a debt instrument was
issued at a substantial premium or discount, an entity should use the amount
allocated to the instrument for accounting purposes, not the total cash proceeds. In
addition, the entity should consider the payoff of the embedded feature that is
being analyzed. For example, if a debt instrument that was issued at par contains a
put option that allows the investor to redeem the instrument at 112 percent of par
value, the debt instrument would effectively be considered to involve a substantial
discount.
The following table outlines and illustrates the application of the four steps
in ASC 815-15-25-42:
|
Steps
|
Examples of Terms That Would Result in a
“Yes” Answer
|
Examples of Terms That Would Result in a
“No” Answer
|
|---|---|---|
|
“Step 1: Is the amount paid upon settlement
(also referred to as the payoff) adjusted based on changes
in an index? If yes, continue to Step 2. If no, continue to
Step 3.”
|
|
|
|
“Step 2: Is the payoff indexed to an
underlying other than interest rates or credit risk? If yes,
then that embedded feature is not clearly and closely
related to the debt host contract and further analysis under
Steps 3 and 4 is not required. If no, then that embedded
feature shall be analyzed further under Steps 3 and 4.”
|
|
|
|
“Step 3: Does the debt involve a substantial
premium or discount? If yes, continue to Step 4. If no,
further analysis of the contract under paragraph
815-15-25-26 is required, if applicable.”
|
|
|
|
“Step 4: Does a contingently exercisable
call (put) option accelerate the repayment of the
contractual principal amount? If yes, the call (put) option
is not clearly and closely related to the debt instrument.
If not contingently exercisable, further analysis of the
contract under paragraph 815-15-25-26 is required, if
applicable.”
|
|
|
As noted in steps 2, 3, and 4 of the decision sequence in ASC 815-15-25-42 for
determining whether an embedded call or put is clearly and closely related to a debt
host, an entity also must consider ASC 815-15-25-26, which applies only to embedded
derivatives “in which the only underlying is an interest rate or interest rate index
. . . that alters net interest payments that otherwise would be paid or received on
an interest-bearing [debt] host contract.” This guidance does not apply to
contingent call and put options embedded in a debt host contract unless the
contingency itself is only related to an interest rate index (e.g., a call that may
only be exercised when LIBOR is at or above 5 percent). An option that can be
exercised only upon the occurrence or nonoccurrence of a specified event that is not
solely related to interest rates (e.g., an IPO or a change in control of the issuer)
would always have a second underlying (e.g., the occurrence or nonoccurrence of the
specified event). Therefore, such contracts would be excluded from the scope of ASC
815-15-25-26.
Example A-1
Embedded Put Option Exercisable Upon a Change in Control
Entity A issues a 10-year note at par, which becomes puttable to the issuer at 102 percent of par plus accrued interest if a change in control occurs at A.
As shown in the table below, A must apply the four-step decision sequence in ASC 815-15-25-42 to evaluate whether the embedded put option is clearly and closely related to the debt host:
Example | Indexed Payoff? (Steps 1 and 2) | Substantial Discount or Premium?
(Step 3) | Contingently Exercisable? (Step 4) | Embedded Option Clearly and Closely Related? |
|---|---|---|---|---|
Debt issued at par is puttable at 102 percent of par, plus accrued interest, in the event of a change in control at A. | No. The amount paid upon settlement is not “adjusted based on changes in an index.” The payoff amount is fixed at 102 percent of par, plus accrued interest. | No. The debt is issued at par and puttable for a premium that is not substantial. | N/A. Analysis is not required because the answer to step 3 is no (i.e., no substantial discount or premium). | The embedded put option is clearly and closely related to the debt host. ASC 815-15-25-26 does not apply, because the change in control is considered a second underlying that is not an interest rate or an interest rate index. |
In this example, a change in control is considered a second underlying of the embedded put option. Because the underlying of the embedded put option is not solely an interest rate or interest rate index, the guidance in ASC 815-15-25-26 does not apply to the analysis of whether the embedded put option is clearly and closely related to the debt host.
With respect to steps 1 and 2 of ASC 815-15-25-42, a payoff is considered
“adjusted based on changes in an index” if the payoff is
variable and changes in response to fluctuations in an
index. In this case, there is only one possible payoff
amount should the contingent event occur (a payoff at 102
percent plus accrued interest), even though the amount paid
is not just the repayment of par plus accrued interest.
For a similar analysis, see Instrument 7 in the illustration in ASC 815-15-55-13.