Appendix A — Embedded Derivative Analysis
Appendix A — Embedded Derivative Analysis
In determining the appropriate accounting for a convertible debt
instrument, an issuer is required to evaluate whether the instrument contains any
embedded features that must be accounted for as a derivative instrument separately
from the host instrument. Examples of such features include equity conversion
features, put and call options, indexed interest rate payments, inverse floating
interest rate payments, leveraged interest rate payments, interest rate caps and
floors, interest rate make-whole features, term-extension options, and foreign
currency features.
Section
2.3 provides an overview of the accounting requirements that apply to
the bifurcation of embedded derivatives in accordance with ASC 815-15. Because this
Roadmap focuses on the issuer’s accounting for convertible debt under ASC 470-20,
however, it does not comprehensively address the accounting requirements for
derivative instruments. This appendix discusses some of the common questions an
issuer may encounter in performing an embedded derivative analysis for a convertible
instrument in accordance with ASC 815.
While an entity may be required to bifurcate embedded derivatives
for recognition and measurement purposes, such features are usually combined with
the host contract in an entity’s balance sheet. In the SEC’s Current Accounting and Disclosure
Issues in the Division of Corporation Finance (as updated
November 30, 2006), the SEC staff indicated that “embedded derivatives should be
presented on a combined basis with the host contract, except in circumstances where
the embedded derivative is a liability and the host contract is equity.”
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:
-
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.
-
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.
-
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:
-
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:
-
One or more underlyings
-
One or more notional amounts or payment provisions or both.
-
-
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.
-
Net settlement. The contract can be settled net by any of the following means:
-
Its terms implicitly or explicitly require or permit net settlement.
-
It can readily be settled net by a means outside the contract.
-
It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
-
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.
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: 
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
|
|
|
|
Conversion rights are an
equity-like term or feature
|
|
|
|
Voting rights are an
equity-like term or feature
|
|
|
|
Protective covenants are a
debt-like term or feature
|
|
|
|
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.
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:
|
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).
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
1
In certain limited circumstances described in
ASC 815-40-25-7 through 25-9, net cash settlement would not necessarily
preclude equity classification.
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.
A.6 Interest Rate Index Embedded in a Debt Host
Generally, interest rates are considered to be clearly and closely related to a
debt host. The guidance in ASC 815-15-25-26 addresses how an entity would assess two
conditions to determine whether an embedded derivative feature in a debt host in
which the only underlying is an interest rate or interest rate index (i.e., an
interest rate-related underlying) is not considered clearly and closely related to
the debt host. ASC 815-15-25-26 states:
For purposes of
applying the provisions of paragraph 815-15-25-1, an embedded derivative in
which the only underlying is an interest rate or interest rate index (such as an
interest rate cap or an interest rate collar) that alters net interest payments
that otherwise would be paid or received on an interest-bearing host contract
that is considered a debt instrument is considered to be clearly and closely
related to the host contract unless [one of two conditions exists.]
The first condition — ASC 815-15-25-26(a) — is as follows:
The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment (that is, the embedded derivative contains a provision that permits any possibility whatsoever that the investor’s [the holder’s or the creditor’s] undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms).
The term “substantially all” in ASC 815-15-25-26 is generally interpreted to mean that at least 90 percent of the original investment (i.e., the undiscounted net cash flows received by the investor over the life of the debt instrument would equal at least 90 percent of the investment balance initially recorded by the investor).
Example A-2
Bond With Leveraged Interest Rate Provision
Company X invests in a $10 million 10-year bond that pays a fixed rate of 6 percent for the first two years and then pays a variable rate calculated as 14 percent minus the product of 2.5 times the three-month LIBOR, without a floor, for the remaining term of the bond. If the three-month LIBOR were to increase significantly, the bond might have a negative return, which would effectively erode its principal. In that case, X might not recover substantially all of its initial investment. The issuer should therefore separately account for the embedded interest rate derivative unless it has elected the option in ASC 815-15-25-4 or ASC 825-10-25-1 to measure the entire hybrid financial instrument at fair value, with changes in fair value recognized in earnings.
The second condition — ASC 815-15-25-26(b) — is as follows:
The embedded derivative meets both of the following conditions:
- There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract (that is, the embedded derivative contains a provision that could under any possibility whatsoever at least double the investor’s initial rate of return on the host contract).
- For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed in (b)(1)), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.
Note that ASC 815-15-25-37 states that the conditions in ASC 815-15-25-26(b)(1) and (b)(2) above do not apply to an embedded call option in a hybrid instrument that contains a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor (issuer/borrower).
Example A-3
Bond Indexed to LIBOR on Leveraged Basis
Company A invests in a 30-year variable-rate debt instrument issued by Company B. The instrument is indexed to the three-month LIBOR (3M LIBOR) plus 4 percent. As of the instrument’s issuance date, the 3M LIBOR was 2 percent. The instrument’s terms also specify that if the 3M LIBOR increases to 5 percent, the debt issuer is required to pay 23 percent for the remaining term of the bonds.
If B were to issue a 30-year variable-rate debt instrument without any embedded derivatives (i.e., the interest rate reset feature), it would pay a coupon of 3M LIBOR plus 6 percent. Consequently, the initial rate of return on the host contract is 8 percent (3M LIBOR of 2 percent plus 6 percent). Company A must determine whether the embedded derivative could at least double its initial rate of return on the host contract, which was 8 percent as of the issuance date, in any of the possible interest rate environments. When the 3M LIBOR increases to 5 percent, the 23 percent interest rate feature more than doubles the initial 8 percent rate of return on the host contract; therefore, the first condition (ASC 815-15-25-26(b)(1)) is satisfied.
To determine whether the second condition (ASC 815-15-25-26(b)(2)) is satisfied, A must assess whether, for any of the possible interest rate scenarios under which its initial rate of return on the host contract would be doubled (i.e., when the 3M LIBOR is at 5 percent), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return on a contract with the same terms as the host contract. When the 3M LIBOR increases to 5 percent, the rate of return on a contract that has the same terms as the host contract (and involves a debtor with a credit quality similar to that of B at debt inception) would be 11 percent (3M LIBOR of 5 percent plus 6 percent). The second condition is therefore also satisfied because when the 3M LIBOR increases to 5 percent, the 23 percent return generated by the embedded derivative feature in the debt is more than twice the 11 percent return (3M LIBOR of 5 percent plus 6 percent) on the contract with the same terms as the host contract.
Companies A and B would each be required to account for the embedded derivative separately unless either has elected the option in ASC 815-15-25-4 or ASC 825-10-25-1 to measure the entire hybrid financial instrument at fair value, with changes in fair value recognized in earnings.
While the conditions in ASC 815-15-25-26(a) and (b) above focus on the
investor’s rate of return and recovery of its investment, if either of those
conditions is satisfied, neither party to the hybrid instrument would consider the
embedded derivative feature to be clearly and closely related to the host contract.
Furthermore, ASC 815-15-25-26 indicates that when an entity assesses whether it
meets one of the conditions, it should not consider whether it is probable that the
condition will be satisfied; the condition should be considered satisfied if there
is any possibility whatsoever that it will be met. Therefore, in the example above,
the probability that the 3M LIBOR will increase to 5 percent is not relevant to the
analysis of whether the condition is met. However, an entity should consider such
probability when valuing the embedded derivative.
See Section A.7 for further discussion of the application of the “double-double” test in ASC 815-15-25-26(b).
A.7 Application of the Double-Double Test in ASC 815
When evaluating whether an embedded derivative in which the only underlying is an interest rate or interest rate index (i.e., an interest rate-related underlying) is clearly and closely related to its interest-bearing host, an entity must apply the test established by ASC 815-15-25-26(b) (i.e., the double-double test). The double-double test consists of two tests that are performed on the date on which the instrument is acquired (or incurred) by the reporting entity.
In the first of the two tests, the entity that performs the evaluation must determine whether there is a possible future interest rate scenario, no matter how remote, in which the embedded derivative would at least double the investor’s initial rate of return on the host contract. In making this assessment, the entity must differentiate the return on the host contract from the return on the hybrid contract. The host contract excludes the effects of the embedded derivative. If an embedded derivative does not pass this test, it would be considered clearly and closely related to its host (provided that it does not meet the condition in ASC 815-15-25-26(a)). If the embedded derivative does pass this test, the entity must perform a second test to determine whether it is clearly and closely related to the host contract.
In the second test, the entity must determine whether, for any of the scenarios identified in the first test for which the investor’s initial rate of return on the host contract would be doubled, the embedded derivative would at the same time result in a rate of return that (1) is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and (2) involves a debtor with a credit quality similar to that of the issuer’s at inception. If the embedded derivative also passes this test, it would not be considered clearly and closely related to its host contract.
If the second test is not passed (and the embedded derivative does not meet the condition in ASC 815-15-25-26(a)), the embedded derivative would be considered clearly and closely related to the host contract.
Example A-4
Bond With Interest Rate Cap Provision
On January 1, 20X1, Company A purchases a bond at par that pays LIBOR. The bond also incorporates an interest rate cap provision stating that A will receive a return of 10 percent if LIBOR equals or exceeds 8 percent as of any interest rate reset date. On the date A purchases the bond, it also could purchase at par a variable-rate bond that does not contain a cap and that pays LIBOR minus 1 percent from a debtor with the same credit quality as the issuer of A’s bond. As of January 1, 20X1, LIBOR is 5 percent. The bond cannot contractually be settled in a manner in which A would not recover substantially all of its initial recorded investment in the bond. To perform the first test in ASC 815-15-25-26(b), A must determine whether there is any interest rate scenario, no matter how remote, under which the embedded derivative (the cap) would at least double its initial rate of return on the host contract. This analysis is summarized in the following table:
Because the first test has been satisfied, A must perform the second test in ASC 815-15-25-26(b) to determine whether the embedded cap is clearly and closely related to its bond host. In this test, A must determine, for any of the possible interest rate scenarios identified above under which A’s initial rate of return on the host contract would be doubled, whether the embedded cap would simultaneously result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and involves a debtor with a credit quality similar to that of the issuer’s at inception. Company A’s analysis for this test can be summarized as follows:
Since both of the ASC 815-15-25-26(b) tests are not met, the embedded cap is considered clearly and closely related to the bond host.
A.8 Credit-Sensitive Payments
ASC 815-15
25-46 The creditworthiness of the debtor and the interest rate on a debt instrument shall be considered to be clearly and closely related. Thus, for debt instruments that have the interest rate reset in the event of any of the following conditions, the related embedded derivative shall not be separated from the host contract:
- Default (such as violation of a credit-risk-related covenant)
- A change in the debtor’s published credit rating
- A change in the debtor’s creditworthiness indicated by a change in its spread over U.S. Treasury bonds.
25-47 If an instrument
incorporates a credit risk exposure that is different from
the risk exposure arising from the creditworthiness of the
obligor under that instrument, such that the value of the
instrument is affected by an event of default or a change in
creditworthiness of a third party (that is, an entity that
is not the obligor), then the economic characteristics and
risks of the embedded credit derivative are not clearly and
closely related to the economic characteristics and risks of
the host contract, even though the obligor may own
securities issued by that third party. This guidance shall
be applied to all other arrangements that incorporate credit
risk exposures that are unrelated or only partially related
to the creditworthiness of the issuer of that instrument.
This guidance does not affect the accounting for a
nonrecourse debt arrangement (that is, a debt arrangement in
which, in the event that the debtor does not make the
payments due under the loan, the creditor has recourse
solely to the specified property pledged as collateral).
With the exception of certain inflation-indexed payment features addressed in ASC 815-15-25-50, if a contingent payment feature embedded in a debt host contract is not an interest rate-related underlying and is not considered a credit-sensitive payment, it is not clearly and closely related to the debt host contract and must be bifurcated as an embedded derivative under ASC 815-15-25-1(a) if the conditions in ASC 815-15-25-1(b) and (c) are met.
Convertible debt instruments often contain provisions that require the issuer to pay additional interest upon the occurrence of an “event of default.” Depending on the situations that result in an event of default, as defined in the convertible debt agreement, such a contingent payment may not be considered a credit-sensitive payment and therefore may not be considered clearly and closely related to the debt host. The table below discusses common situations that may be described as events of default and whether such triggering events constitute a credit-sensitive payment.
Triggering Event | Credit-Sensitive Payment? |
|---|---|
Any representation or warranty made by the issuer that is not correct | Yes |
Failure to perform or comply with financial or nonfinancial covenants | Yes, unless the covenants include items that do not affect the issuer’s credit risk |
Bankruptcy or insolvency | Yes |
Cross default on other indebtedness | Yes, unless the default on the other indebtedness arises from events that are not credit-related |
Invalidity of or failure to maintain loan or collateral documents | Yes |
Nonpayment of principal or interest when due | Yes |
Judgments or orders against the issuer exceeding a specific amount | Yes |
Revocation of a license or permit to perform business operations that results in a material adverse effect | Yes |
Criminal events of the issuer | Yes |
A change in control of the issuer | No |
Key person event | Depends on facts and circumstances |