Expand
Resize
Add to favorites
To apply the embedded derivative model, it is necessary to understand the economic characteristics and risks of the host contract. Certain instruments, such as preferred stock, have characteristics of both debt and equity, and the determination of the host contract will have a direct impact on the conclusion of whether an embedded component should be separated. For example, a conversion feature in preferred stock that is deemed an equity host would not be separated by the investor because the conversion option is clearly and closely related to an equity host contract. In contrast, a conversion feature in preferred stock deemed to be a debt host would not be clearly and closely related; therefore, it would be separated by the investor if the remaining criteria in ASC 815-15-25-1 are met.

4.5.1 Determining if an equity contract is a debt or equity host

To determine its nature, the reporting entity needs to consider the host contract’s underlying economic characteristics and risks. Whether a host instrument is an equity or debt host is not determined by its balance sheet classification. An instrument may be classified as equity, but may be considered a debt host contract for purposes of evaluating embedded components.
Determining whether a hybrid instrument that is legally an equity instrument (e.g., a preferred share) is a debt or equity host contract requires judgment. As discussed in ASC 815-15-25-17A, all of the contractual and implied terms of the preferred share, such as the existence of a redemption feature or conversion option, should be considered when determining the nature of the host instrument as debt or equity.

ASC 815-15-25-17A

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. In 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. For example, 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. Rather, the nature of the host contract depends on the economic characteristics and risks of the entire hybrid financial instrument.

Excerpt from ASC 815-15-25-17C

When applying the guidance in paragraph 815-15-25-17A, …an entity shall consider not only whether the relevant terms and features are debt-like versus equity-like, but also the substance of those terms and features (that is, the relative strength of the debt-like or equity-like terms and features given the facts and circumstances). In assessing the substance of the relevant terms and features, each of the following may form part of the overall analysis and may inform an entity’s overall consideration of the relative importance (and, therefore, weight) of each term and feature among other terms and features:

  1. The characteristics of the relevant terms and features themselves (for example, contingent versus noncontingent, in-the-money versus out-of-the-money)
  2. The circumstances under which the hybrid financial instrument was issued or acquired (for example, issuer-specific characteristics, such as whether the issuer is thinly capitalized or profitable and well-capitalized)
  3. The potential outcomes of the hybrid financial instrument (for example, the instrument may be settled by the issuer issuing a fixed number of shares, the instrument may be settled by the issuer transferring a specified amount of cash, or the instrument may remain legal-form equity), as well as the likelihood of those potential outcomes. The assessment of the potential outcomes may be qualitative in nature.

Figure DH 4-6 shows some common attributes that should be analyzed to determine the nature of the host contract. None of these factors alone is determinative of the nature of a host contract; the terms and conditions as a whole should be evaluated. ASC 815-15-25-17D provides additional guidance on assessing each of these attributes.
Figure DH 4-6
Analyzing the nature of the host contract
Attribute
Indicates the instrument is debt-like
Indicates the instrument is equity-like
Redemption provision
Conversion option
Cumulative or mandatory fixed dividends
Discretionary dividends based on earnings
Voting rights
Collateral requirement
Participation in the residual equity of the issuer
Preference in liquidation

4.5.2 Embedded put and call options

Put features allow an equity holder to require the issuer to reacquire the equity instrument for cash or other assets; call features allow the issuer to reacquire the equity instrument.
As discussed in ASC 815-15-25-20, put and call features are typically not considered clearly and closely related to equity hosts and should be accounted for separately as a derivative provided the other requirements in ASC 815-15-25-1 are met. However, if the issuer concludes that the embedded feature meets the requirements for the scope exception for certain contracts involving an entity’s own equity in ASC 815-10-15-74(a) (i.e., the put or call option would be classified in equity), then the put or call option would not have to be separated (because it wouldn’t be accounted for as a derivative if it were freestanding). For example, a call option that allows the issuer of an equity instrument (such as common stock) to reacquire that equity instrument may meet this exception; if the call option were embedded in the related equity instrument, it would not be separated from the host contract by the issuer.
Expand

Welcome to Viewpoint, the new platform that replaces Inform. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.

Your session has expired

Please use the button below to sign in again.
If this problem persists please contact support.

signin option menu option suggested option contentmouse option displaycontent option contentpage option relatedlink option prevandafter option trending option searchicon option search option feedback option end slide