2.3 Embedded Derivatives
2.3.1 Interaction Between ASC 470-20 and ASC 815-15
ASC 470-20
25-1 The guidance in this Section shall be considered after consideration of the guidance in . . . Subtopic 815-15 on bifurcation of embedded derivatives . . . .
Many of the requirements in ASC 470-20 related to the accounting for convertible debt instruments (e.g., the CCF and BCF guidance) do not apply to a conversion feature that must be bifurcated and accounted for as derivative instrument under ASC 815-15. Therefore, an issuer needs to determine whether ASC 815-15 requires bifurcation of the conversion feature before it assesses whether ASC 470-20 applies. However, if a feature other than the conversion feature (e.g., a call or put option) must be bifurcated from a convertible debt instrument, the conversion feature is not exempt from analysis under ASC 470-20. For example, an entity may be required to separate a convertible debt instrument into liability and equity components under the CCF or BCF guidance in ASC 470-20 even if the instrument contains a bifurcated derivative other than the embedded conversion feature.
2.3.2 Bifurcation
2.3.2.1 Overall Framework
ASC Master Glossary
Embedded Derivative
Implicit 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.
Hybrid Instrument
A contract that embodies both an embedded derivative and a host contract.
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.)
To determine whether any embedded feature in a convertible instrument must be bifurcated and
accounted for separately as a derivative instrument, an entity must evaluate the instrument’s terms,
which may include, for example, one or more of the following features:
- A right or obligation to convert the instrument into the issuer’s equity instruments (e.g., common or preferred stock), including a right or obligation that is contingent on the occurrence of a specified event (e.g., debt that is mandatorily convertible into the issuer’s equity shares upon an initial public offering [IPO]).
- The holder’s right to require the issuer to accelerate the repayment of the stated amount (i.e., a put or redemption option).
- The issuer’s right to prepay the stated amount (i.e., a call option).
- Terms that accelerate the repayment of principal or interest upon the occurrence or nonoccurrence of an event (e.g., a default or an IPO).
- Term-extension features.
- Indexed principal or interest payments (e.g., to benchmark interest rates, credit spreads, inflation rates, commodity prices, equity prices, revenues, or other underlyings).
- Interest payments that are leveraged or inversely related to market interest rates or subject to a collar, cap, or floor.
- Interest payments that are triggered upon the occurrence or nonoccurrence of an event that is unrelated to an interest rate index or the issuer’s credit risk.
- Foreign currency features.
Under ASC 815-15-25-1, an entity is required to separately account for a feature embedded within
another contract (the host contract) if the following three conditions are met:
- The embedded feature and the host contract have economic characteristics and risks that are not clearly and closely related. For example, changes in the fair value of an equity interest — such as an equity conversion feature — are not clearly and closely related to changes in the interest rates on a debt host contract.
- The hybrid instrument (i.e., the combination of the embedded feature and its host contract) is not remeasured at fair value, with changes in fair value recorded immediately through earnings (e.g., under the fair value option election in ASC 815-15-25-4 or ASC 825-10).
- The embedded feature — if issued separately — would be accounted for as a derivative instrument under ASC 815-10. In evaluating whether this condition is met, the entity considers the definition of a derivative in ASC 815-10 and the scope exceptions from derivative accounting in ASC 815-10 and ASC 815-15.
There is no requirement to evaluate the three bifurcation conditions in any
particular order. Because all three must be met, the analysis can be
simplified if it is readily apparent that any one condition is not
satisfied. For example, if the instrument is accounted for at fair value,
with changes in fair value recognized in earnings (such as under the fair
value option in ASC 825-10), the feature would not be bifurcated
irrespective of whether the other two bifurcation conditions are met (see
Section
2.5). Therefore, evaluation of the other conditions might not be
necessary.2 Similarly, the analysis can be simplified if it is readily apparent
that the feature is clearly and closely related to the host contract or
would not be accounted for as a derivative instrument if it was a
freestanding contract.
In determining whether bifurcation is required, the entity should not rely
solely on how terms are formally described in the contractual provisions but
also should consider the economic payoff profile of the various terms. For
example, a term that is described as a conversion option might more
appropriately be evaluated as a put option if it represents a right for the
investor to receive shares worth a fixed monetary amount upon exercise (see
Sections
2.4 and 3.3). It may also be appropriate to evaluate terms with
similar economic payoff profiles on a combined basis. For example, the
contractual terms might include multiple conversion features, such as
conversion features that are at the option of the issuer or holder or are
contingent on different events. If their economic payoff profiles are
similar (e.g., they all economically represent a feature that is convertible
into the issuer’s common stock), it may be appropriate to evaluate them for
bifurcation as a single embedded feature.
In its balance sheet, an entity typically presents a bifurcated embedded derivative on a combined basis with the host contract. In the SEC’s Current Accounting and Disclosure Issues in the Division of Corporation Finance (as updated November 30, 2006), the SEC staff stated that “[a]lthough bifurcated for measurement purposes, 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.”
2.3.2.2 Condition 1 — Not Clearly and Closely Related
The first bifurcation condition in ASC 815-15-25-1 is that the embedded feature and the host contract have economic characteristics and risks that are not clearly and closely related. In evaluating whether this condition is met, the entity must determine the nature of the host contract and identify the economic characteristics and risks of the embedded feature. A convertible instrument issued in the form of debt is considered to contain a debt host contract. A convertible instrument issued in the form of a share must be evaluated to determine whether it contains a debt or an equity host contract (see Section A.2).
The table below provides examples of embedded features that may or may not be
considered clearly and closely related to a debt host contract. The embedded
features are defined on the basis of the economic profile of the payment
rather than the form used for settlement (i.e., cash or shares). However,
the assessment could differ depending on the facts and circumstances and the
application of other specific requirements of ASC 815.
|
Host Contract
|
Clearly and Closely Related
|
Not Clearly and Closely Related
|
|---|---|---|
|
Debt
|
|
|
2.3.2.3 Condition 2 — Hybrid-Instrument Accounting
The second bifurcation condition in ASC 815-15-25-1 is that the hybrid
instrument is not remeasured at fair value, with changes in fair value
recognized in earnings. If an issuer has applied the fair value option in
ASC 815-15-25-4 or ASC 825-10 to a convertible debt instrument (see
Sections
2.5 and 3.2), an embedded feature would not be bifurcated. However,
ASC 825 prohibits an entity from electing the fair value option for a
financial instrument that would be classified, in whole or in part, as
equity. Because ASC 470-20 requires the issuer of certain types of
convertible debt instruments to separate them into liability and equity
components at issuance (e.g., instruments with CCFs or noncontingent BCFs),
the issuer cannot elect the fair value option for such instruments.
Effectively, therefore, an issuer needs to consider whether ASC 470-20
requires the convertible debt instrument to be separated into liability and
equity components before it can determine whether the fair value option is
available for that instrument.
When assessing whether an embedded feature must be bifurcated, an entity should
not consider a liability that is measured at settlement value in accordance
with ASC 480-10-35-3 (see Sections 4.3.1.2 and 5.3.1.3 of Deloitte’s Roadmap
Distinguishing
Liabilities From Equity) to be accounted for at fair
value. Although the settlement value might approximate fair value, the
calculation of a liability’s settlement value does not take into account all
of the attributes of an instrument that are included in a fair value
estimate — for example, the time value of an option. Thus, an instrument
that is remeasured at settlement value may contain an embedded feature that
must be bifurcated.
2.3.2.4 Condition 3 — Derivative Instrument
The third bifurcation condition in ASC 815-15-25-1 is that the embedded feature would have been accounted for as a derivative instrument under ASC 815 if it were a separate freestanding instrument. To determine whether this condition has been satisfied, the entity evaluates whether the feature (1) would have met the definition of a derivative instrument in ASC 815-10 on a stand-alone basis and (2) meets any scope exception described in ASC 815-10 and ASC 815-15. An embedded feature would not be bifurcated if it does not meet the definition of a derivative instrument or it qualifies for a scope exception.
To determine whether the embedded feature would have met the definition of a derivative instrument on a freestanding basis, an entity considers whether the instrument possesses the three characteristics of a derivative instrument listed in ASC 815-10-15-83:
- It has one or more underlyings and one or more notional amounts or payment provisions or both — The settlement of a derivative depends on the interaction between (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both, defined as follows:
- An underlying is a variable whose changes affect the cash flows or fair value of the contract. Examples of underlyings include security prices, commodity prices, interest rates, exchange rates, or the occurrences or nonoccurrences of a specified event. For example, one underlying of an embedded conversion feature is the issuer’s stock price.
- A notional amount is a quantity specified in the contract. Examples of notional amounts include monetary amounts (e.g., principal or face amounts) or a number of equity shares.
- A payment provision is a clause that, as indicated in ASC 815-10-15-93, “specifies a fixed or determinable settlement [amount] if the underlying behaves in a specified manner.” Examples include fixed payments that are contingent on the occurrence or nonoccurrence of an event.
- It requires no initial net investment or one that is smaller than that required under comparable contracts — Under ASC 815-10-15-83(b), a derivative “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.” In accordance with ASC 815-15-25-1(c), the initial investment in a hybrid instrument is not considered the initial net investment for an embedded feature in that instrument. Instead, the initial net investment in the embedded feature is the amount an entity would have been required to invest in a freestanding contract with terms that are similar to those of the embedded feature. For example, the initial net investment in a conversion feature embedded in a debt instrument is the fair value of that feature, rather than the fair value of the convertible debt or the shares that would be delivered upon exercise of the conversion feature. Thus, the initial net investment characteristic is generally met for an embedded derivative.
- Net settlement is permitted — Under ASC 815, a contract or feature is not considered a derivative unless it can be settled net. The net settlement characteristic is met in any of the following circumstances:
- The contractual terms require or permit net settlement. In a contractual net settlement, neither party is required to deliver an asset that is associated with the underlying and whose principal amount, stated amount, face value, number of shares, or other denomination is equal to the notional amount. One form of contractual net settlement is a one-way transfer of cash or assets, such as a net amount of cash or a net number of shares (“cashless exercise”). If the contractual terms require or permit either party to elect net settlement, the net settlement characteristic is met even if the item delivered upon settlement is not readily convertible to cash (e.g., private-company shares). In accordance with ASC 815-10-15-107, the exercise of an embedded put, call option, or prepayment option in a debt host contract is considered a contractual net settlement “because neither party is required to deliver an asset that is associated with the underlying.”
- An established market mechanism exists that facilitates net settlement outside of the contract, such as the ability to sell the derivative on an exchange. This condition is typically not met for an embedded feature.
- The contract is settled in a manner in which the recipient’s position is not substantially different from that in a net settlement. For example, if a contract is settled by a two-way (gross) exchange of items that are readily convertible to cash or are derivatives, the net settlement characteristic is met. According to the ASC master glossary, the term “readily convertible to cash” means that an asset has both “[i]nterchangeable (fungible) units” and “[q]uoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.” For example, an embedded conversion feature that must be settled by the physical delivery of the shares underlying the feature in exchange for the extinguishment of the host debt contract would meet the net settlement characteristic if the shares are readily convertible to cash.
In addition, to determine whether the embedded feature would have been accounted for as a derivative
under ASC 815 if it had been a freestanding contract, the entity should consider whether any of the
scope exceptions in ASC 815-10-15 and ASC 815-15-15 apply to the feature. Examples of exceptions
that may be relevant for embedded features in convertible debt instruments include those related to:
- Contracts that are both indexed to the entity’s own stock and classified in stockholders’ equity (see ASC 815-10-15-74(a) and Section 2.3.3). For example, an entity would evaluate an embedded conversion feature to determine whether it meets this scope exception.
- Certain loan commitments (see ASC 815-10-15-69 through 15-71). For example, an entity may evaluate a term extension option embedded in a debt instrument to determine whether it meets this scope exception.
- Certain contracts traded on an exchange if, as indicated in ASC 815-10-15-59(d), the underlying on which the settlement is based is “[s]pecified volumes of sales or service revenues of one of the parties to the contract.” For example, an entity would evaluate interest payments indexed to sales revenue to determine whether they meet this scope exception.
- Registration payment arrangements (see ASC 815-10-15-82 and Section 3.4.3).
2.3.3 Bifurcation Analysis for Embedded Conversion Features
The application of the bifurcation conditions to an equity conversion feature embedded in a debt instrument is multifaceted and often complex. Although there are additional factors that should be considered (see Appendix A), the analysis of whether an equity conversion feature should be bifurcated from a debt host contract under ASC 815-15 often centers on whether the feature meets (1) the net settlement characteristic in the definition of a derivative and, if so, (2) the scope exception in ASC 815-10-15-74(a) for certain contracts issued by the reporting entity that are both indexed to its own stock and classified in stockholders’ equity in its statement of financial position. If an equity conversion feature is embedded in a contract in the legal form of a share (e.g., convertible preferred stock) but the hybrid financial instrument is classified as a liability for accounting purposes, the host contract is generally a debt host (see Section A.2). Therefore, the analysis is similar to that of an equity conversion feature embedded in a legal-form debt instrument (i.e., the equity conversion feature is not clearly and closely related to the host contract).
For equity conversion features that require physical settlement into a fixed number of shares, whether the conversion option meets the net settlement characteristic in the definition of a derivative often depends on whether the underlying shares are readily convertible to cash. The net settlement criterion would be met if the instruments require or permit explicit net settlement (either in net cash or net shares). In evaluating whether a conversion feature meets the net settlement characteristic, the entity should consider all of the convertible instrument’s terms (e.g., redemption and liquidation features). Sometimes, a conversion feature stipulates that rather than having shares delivered, the issuer or investor may choose to have the instrument settle in a cash amount equal to the value of the shares that would have been received in exchange for the convertible instrument. In this case, the terms of the conversion feature explicitly permit net settlement. Other times, the instrument may be redeemable by the holder and, upon redemption, the holder receives a cash amount 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. While the conversion feature, according to its terms, may only be settled physically, the redemption feature effectively permits the conversion feature’s net cash settlement.
The determination of whether an embedded equity conversion feature meets the scope exception for certain contracts on the entity’s own equity includes an evaluation of whether the feature is considered indexed to own equity under ASC 815-40-15 and, if so, whether the feature meets additional equity classification conditions in ASC 815-40-25. Common convertible debt terms that should be considered as part of this analysis include:
- Exercise contingencies (e.g., conversion rights that are contingent on (1) the satisfaction of a share price condition or a convertible debt trading price condition or (2) specified corporate events); see Section 4.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
- Conversion rate adjustments (e.g., antidilution adjustments, down-round protection, and fundamental change make-whole features); see Section 4.3 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
- Settlement provisions (e.g., contingent cash settlement provisions); see Chapter 5 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
A convertible debt instrument might qualify as conventional convertible debt
under ASC 815-40-25-39 if the holder can realize the value of the conversion
option only by exercising it and receiving the entire proceeds in a fixed number
of shares or the equivalent amount of cash at the issuer’s discretion. In that
case, some of the equity classification conditions in ASC 815-40-25 would not
apply (see Section
5.5 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity).
A conversion feature might begin or cease to meet the bifurcation criteria under
ASC 815-15 after the initial recognition of the instrument in which it is
embedded. For instance, the assessment of whether a feature meets the equity
classification conditions in ASC 815-40-25 may change if the entity authorizes
the issuance of additional shares. The accounting analysis might also change if
a conversion feature becomes readily convertible to cash because a market
develops for the underlying shares. In these circumstances, the applicability of
ASC 470-20 to the instrument may be affected. To ensure that the accounting for
an instrument remains appropriate, the issuer should monitor such changes (see
Section 5.4 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity).
If separation of the conversion feature is required after the initial recognition of the convertible
instrument, the feature is bifurcated and recognized at fair value at the time it begins to meet the
bifurcation criteria. If no amount was previously allocated to equity, a portion of the current carrying
amount of the convertible instrument equal to the current fair value of the feature is allocated to the
embedded derivative (in accordance with ASC 815-15-30-2). However, if an amount attributable to the
equity feature was previously allocated to equity under the CCF guidance in ASC 470-20, the difference
between that amount and the fair value of the conversion option as of the date of reclassification is
accounted for under ASC 470-20-35-19 as an adjustment to equity.
If a conversion feature that was bifurcated from its host contract subsequently
meets the conditions for equity classification in ASC 815-40, it would no longer
meet the bifurcation criteria in ASC 815-15 and therefore should no longer be
classified as an asset or a liability. However, any previously recognized gains
and losses should not be reversed. Instead, the carrying amount of the embedded
derivative (i.e., the feature’s fair value as of the date of the
reclassification) should be reclassified to shareholders’ equity (see Section 6.4.2 of this
Roadmap and Section
6.4 of Deloitte’s Roadmap Contracts on an Entity’s Own
Equity). Any remaining debt discount (that arose from the
original bifurcation) should continue to be amortized. The entity also should
provide the disclosures required by ASC 815-15-50-3, as applicable.
Appendix A of this publication includes additional guidance on key aspects of the embedded derivative
analysis that an issuer performs for a convertible debt instrument.
Footnotes
2
In some cases, an entity will need to determine
whether the embedded conversion feature would require bifurcation
before the entity can apply the fair value option. This is because
ASC 825-10-15-5(f) precludes application of the fair value option to
any financial instrument that is, in whole or in part, classified by
the issuer as a component of shareholders’ equity (including
temporary equity) (e.g., a convertible debt instrument within the
scope of the Cash Conversion subsections of ASC 470-20 or a
convertible debt instrument that contains a noncontingent BCF). See
Sections
2.5 and 3.2.