2.3 Derivatives

Some instruments that must be classified as assets or liabilities under ASC 480 have all of the characteristics of a derivative instrument in ASC 815-10-15-83. In accordance with ASC 815-10-15-74(d), if such instruments are physically settled forward contracts to repurchase equity shares for cash, they are exempt from the scope of the derivative accounting requirements in ASC 815. Instead, the accounting guidance in ASC 480 applies (see Chapter 5). Other instruments within the scope of ASC 480 that have all the characteristics of derivative instruments fall within the scope of both ASC 480 and ASC 815 unless one of the scope exceptions in ASC 815 applies. Practically, this means that an entity may be required to apply the disclosure requirements of both ASC 480 and ASC 815 to such instruments. Further, in accordance with ASC 815, such instruments are measured subsequently at fair value, with changes in fair value recognized in earnings, unless they qualify as hedging instruments in a cash flow or net investment hedge, in which case all or a portion of the change in fair value is recognized in other comprehensive income.

An option or forward that is outside the scope of the derivative accounting requirements in ASC 815 (e.g., because it does not meet the net settlement characteristic in the FASB’s definition of a derivative) would nevertheless be accounted for at fair value, with changes in fair value recognized in earnings, if it is within the scope of ASC 480 unless it is a forward contract that requires physical settlement by repurchase of a fixed number of the issuer’s equity shares in exchange for cash (see Section 5.3).

ASC 480 does not apply in an entity’s evaluation of whether an embedded feature should be bifurcated as an embedded derivative under ASC 815-15. For example, in determining whether an embedded feature qualifies for the scope exception in ASC 815-10-15-74(a) for certain contracts that are both indexed to, and classified in, stockholders’ equity (e.g., a written put option embedded in a share), an entity disregards the classification guidance in ASC 480. Instead, the entity assesses whether the feature qualifies for that scope exception by applying the indexation and classification guidance in ASC 815-40 (see Section 2.3.3) and any other relevant guidance other than ASC 480 to the embedded put feature.

A financial instrument within the scope of ASC 480 could potentially contain a feature that must be bifurcated as an embedded derivative under ASC 815-15-25-1. For example, the redemption amount of a mandatorily redeemable financial instrument that is classified as a liability under ASC 480 might be indexed to the price of gold. If so, the issuer should assess whether the indexation to gold must be separated as an embedded derivative under ASC 815-15. ASC 815-15-55-110 through 55-113 illustrate the application of the “clearly and closely related” criterion in an entity’s bifurcation analysis to mandatorily redeemable preferred stock for which the redemption amount is indexed to the price of gold or a fixed amount of a specified foreign currency. The host contract that remains after an embedded feature has been bifurcated as an embedded derivative under ASC 815-15 should be analyzed separately from the embedded derivative in the measurement under ASC 480-10-35 (see Section 4.2.1).

ASC 815-40 addresses the accounting for contracts indexed to, and potentially settled in, the issuer’s equity shares (e.g., purchased put or call options, written call options, and forward sale contracts). ASC 815-40-15-3(e) specifies that freestanding financial instruments within the scope of ASC 480 are exempt from ASC 815-40. Accordingly, ASC 815-40 does not apply to freestanding contracts indexed to, and potentially settled in, the issuer’s equity shares if they are required to be classified as assets or liabilities under ASC 480 (e.g., freestanding written put options and freestanding forward purchase contracts on own equity). This implies that an entity needs to assess whether a contract is within the scope of ASC 480 before it can determine whether to apply ASC 815-40 to the contract. See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for a comprehensive discussion of the application of ASC 815-40.

The table in ASC 480-10-55-63 illustrates how an entity would classify, in accordance with ASC 480, freestanding written put options and forward purchase contracts under which the issuer has agreed to buy shares at a specified price on a future date. Irrespective of whether such an instrument requires physical settlement, net cash settlement, or net share settlement, or whether it gives the issuer or the counterparty a choice of settlement methods, the instrument is classified as an asset or a liability under ASC 480.

If a forward contract requires physical settlement by repurchase of a fixed number of the issuer’s equity shares for cash, it is classified as a liability under ASC 480-10-25-8 and accounted for in a manner similar to a treasury stock repurchase with borrowed funds (see Section 5.3.1). Other forward purchase contracts and written put options that require or may require the issuer to settle its obligation under the contract by transferring assets are classified as assets or liabilities under ASC 480-10-25-8 and accounted for at fair value under ASC 480 (see Sections 5.1 and 5.3.2). Such contracts include those that require net cash settlement, permit the issuer to choose between net cash or physical settlement (but not net share settlement), and give the counterparty a settlement choice if at least one of the options is physical settlement or net cash settlement. Forward purchase contracts and written put options that require or permit the issuer to settle its obligation under the contract net in shares are classified as assets or liabilities under ASC 480-10-25-14(c) and accounted for at fair value under ASC 480 (see Sections 6.1.4 and 6.3).