H

A GUIDE TO ACCOUNTING FOR DERIVATIVES

January 2023
A GUIDE TO ACCOUNTING
FOR DERIVATIVES
January 2023
A GUIDE TO ACCOUNTING FOR DERIVATIVES
This edition of A Guide to Accounting for Derivatives has been produced by the National Professional
Standards Group of RSM US LLP.

We would like to acknowledge the efforts of the contributors to the January 2023 edition of this
publication:

• Michael Gaiso, Senior Director, RSM US LLP

• Monique Cole, Princpal, RSM US LLP

January 2023

The FASB material is copyrighted by the Financial Accounting Foundation, 801 Main Avenue, Norwalk, CT
06851, and is used with permission.
JANUARY 2023

TABLE OF CONTENTS
1. Introduction to derivatives and how they are accounted for ...................................... 1
1.1 Overview ............................................................................................................................................ 1
1.2 How are derivatives accounted for? ............................................................................................... 2
1.3 What is a derivative? ........................................................................................................................ 3
1.3.1 Why do entities use derivatives? .......................................................................................... 4
1.3.1.1 Using derivatives for trading purposes ................................................................ 4
1.3.1.2 Using derivatives for risk management purposes ............................................... 5
1.4 Hidden derivatives ............................................................................................................................ 6
1.5 How are derivatives transacted? .................................................................................................... 7
1.6 Common types of derivative contracts .......................................................................................... 7
2. The scope of ASC 815 and the determination of what is a derivative .......................11
2.1 Scope of ASC 815 ........................................................................................................................... 11
2.1.1 Unit of account for scope purposes .................................................................................... 11
2.1.2 Freestanding or embedded ................................................................................................ 11
2.1.3 Viewing multiple contracts as a unit ................................................................................... 11
2.2 The determination of what is a derivative within the scope of ASC 815 .................................. 14
2.2.1 Definition of derivative instrument ...................................................................................... 14
2.2.1.1 Underlying ......................................................................................................... 15
2.2.1.2 Notional amount or payment provision .............................................................. 16
2.2.1.2.1 Determining the notional amount in requirements contracts ........ 17
2.2.1.3 Initial net investment .......................................................................................... 20
2.2.1.4 Net settlement ................................................................................................... 24
2.2.1.4.1 Contractual net settlement............................................................ 24
2.2.1.4.2 Net settlement through a market mechanism............................... 28
2.2.1.4.3 Net settlement by the delivery of a derivative instrument or an
asset that is readily convertible to cash........................................ 32
2.3 Scope exceptions ........................................................................................................................... 39
2.3.1 Regular-way security trades ............................................................................................... 42
2.3.1.1 “When-issued” or “to-be announced” (TBA) securities...................................... 43
2.3.1.2 Repurchase agreements, wash sales and short sales...................................... 44
2.3.2 Normal purchases and normal sales .................................................................................. 44
2.3.2.1 Normal terms ..................................................................................................... 46
2.3.2.2 Clearly and closely related underlying .............................................................. 46
2.3.2.3 Probable physical settlement ............................................................................ 47
2.3.2.4 Documentation .................................................................................................. 48
2.3.2.4.1 Level of application ....................................................................... 48
2.3.2.5 Futures contracts ............................................................................................... 49
2.3.2.6 Contracts with optionality features .................................................................... 49
2.3.2.7 Electricity contracts ........................................................................................... 51
2.3.2.7.1 Power purchase or sales agreements .......................................... 52
2.3.2.8 Take-or-pay contracts ....................................................................................... 55
2.3.2.8.1 Contracts that meet the definition of a derivative after
inception ....................................................................................... 55
2.3.3 Certain insurance contracts and upon the adoption of ASU 2018-12, market risk
benefits ............................................................................................................................... 55
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2.3.4 Certain financial guarantee contracts ................................................................................. 57

2.3.5 Certain nonexchange traded contracts .............................................................................. 60
2.3.5.1 Climatic, geological or other physical variable .................................................. 60
2.3.5.2 Nonfinancial asset or liability ............................................................................. 62
2.3.5.2.1 Equity kicker ................................................................................. 63
2.3.5.3 Specified volumes of sales or service revenues ............................................... 64
2.3.6 Derivative instruments that impede sale accounting .......................................................... 64
2.3.7 Investments in life Insurance .............................................................................................. 66
2.3.8 Certain investment contracts .............................................................................................. 66
2.3.8.1 Synthetic guaranteed investment contracts ...................................................... 66
2.3.9 Certain loan commitments .................................................................................................. 66
2.3.10 Certain interest-only strips and principal-only strips.......................................................... 66
2.3.11 Certain contracts involving an entity’s own equity ............................................................ 67
2.3.11.1 Contracts that are indexed to an entity’s own stock and are classified in
stockholders’ equity ........................................................................................... 68
2.3.11.2 Contracts subject to ASC 718 ........................................................................... 68
2.3.11.3 Contracts to facilitate a business combination .................................................. 69
2.3.11.4 Fixed-for-fixed forward contracts ....................................................................... 69
2.3.12 Leases ............................................................................................................................... 69
2.3.13 Residual value guarantees ................................................................................................ 70
2.3.14 Registration payment arrangements ................................................................................. 70
2.3.15 Certain Fixed-Odds Wagering Contracts .......................................................................... 70
3. Embedded derivatives ..................................................................................................71
3.1 Overview .......................................................................................................................................... 71
3.1.1 Embedded derivative terminology ...................................................................................... 72
3.1.2 Scope exceptions ............................................................................................................... 72
3.1.3 Identifying potential embedded derivatives ........................................................................ 75
3.2 Derivative analysis of embedded features ................................................................................... 77
3.2.1 Clearly and closely related to the host contract ................................................................. 78
3.2.1.1 Hybrid instruments in the form of a share that have characteristics of both
debt and equity .................................................................................................. 79
3.2.1.2 Hybrid instruments that are not in the form of a share ...................................... 82
3.2.2 Instrument is not remeasured at fair value ........................................................................ 83
3.2.3 Embedded component would be accounted for as a derivative ....................................... 83
3.3 Application of the embedded derivative guidance to various types of host contracts .......... 84
3.3.1 Hybrid instruments with a debt host contract .................................................................... 84
3.3.1.1 Interest rate features, including leverage factors .............................................. 84
3.3.1.1.1 Doubling the initial and market rate of return ............................... 87
3.3.1.1.2 Interest rate reset features related to the elimination of LIBOR ... 88
3.3.1.1.3 Interest rate caps and floors ......................................................... 89
3.3.1.1.4 Inflation-linked bonds .................................................................... 89
3.3.1.1.5 Default interest ............................................................................. 90
3.3.1.2 Beneficial interests in securitizations................................................................. 90
3.3.1.3 Commodity indexed payments .......................................................................... 92
3.3.1.4 Loans that enable the lender or investor to participate in the appreciation
of the financed property, expected residual profit or a share of net earnings
or operating cash flows ..................................................................................... 93
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3.3.1.5
Redemption options and other features that can accelerate payoff .................. 94
3.3.1.6
Conversion options ............................................................................................ 99
3.3.1.7
Term extension feature ................................................................................... 100
3.3.1.8
Equity indexed payments ................................................................................ 100
3.3.1.9
Illustrative examples of applying the embedded derivative guidance to
common features within debt host contracts ................................................... 100
3.3.2 Hybrid instruments with an equity host contract............................................................... 103
3.3.2.1 Redemption options (Put and (or) call options) ............................................... 103
3.3.2.2 Conversion options .......................................................................................... 104
3.3.2.3 Rights offering features ................................................................................... 104
3.3.2.4 Illustrative examples of applying the embedded derivative guidance to
common features within equity host contracts ................................................ 104
3.3.3 Hybrid instruments with a lease host contract.................................................................. 105
3.3.3.1 Illustrative examples of applying the embedded derivative guidance to
common features within lease host contracts ................................................. 105
3.3.4 Hybrid instruments with an insurance host contract ........................................................ 107
3.3.4.1 Dual-trigger insurance contracts ..................................................................... 107
3.3.4.2 Variable annuities in general ........................................................................... 107
3.3.4.3 Equity-indexed annuities ................................................................................. 109
3.3.4.4 Equity-indexed life insurance contracts ........................................................... 110
3.3.5 Hybrid instruments with an executory host contract ........................................................ 110
3.3.5.1 Caps and floors embedded in purchase contracts .......................................... 111
3.4 Accounting for hybrid instruments ............................................................................................ 111
3.4.1 Allocating basis ................................................................................................................ 112
3.4.2 Asymmetry amongst counterparties ................................................................................. 113
3.4.3 Timing and frequency of the embedded derivative assessment ...................................... 113
4. Presentation and Disclosure ......................................................................................115
4.1 General presentation requirements ............................................................................................ 115
4.1.1 Presentation on the statement of financial position ......................................................... 115
4.1.1.1 Classification ................................................................................................... 115
4.1.1.2 Offsetting ......................................................................................................... 116
4.1.1.3 Special considerations for certain centrally cleared derivatives ...................... 118
4.1.2 Presentation on the statement of financial performance .................................................. 119
4.1.2.1 Presentation of the results of economic hedging ............................................ 119
4.1.2.2 Employee and nonemployee stock options ..................................................... 119
4.1.2.3 Hedging instruments ....................................................................................... 119
4.1.3 Presentation of hybrid instruments and a derivative that has been bifurcated from
a host contract .................................................................................................................. 121
4.1.4 Presentation of derivative transactions on the statement of cash flows .......................... 122
4.2 General disclosure requirements ............................................................................................... 122
4.2.1 ASC 815-10 Disclosure requirements for derivatives and related hedging activities ...... 123
4.2.1.1 Qualitative disclosures: How and why the entity uses derivatives .................. 123
4.2.1.2 Overall quantitative disclosures....................................................................... 125
4.2.1.2.1 Example tabular disclosure for hedged items in fair value
hedges ........................................................................................ 136
4.2.1.2.2 Trading derivatives ..................................................................... 136
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4.2.1.3 Basis adjustment considerations under the last-of-layer or portfolio layer

method ............................................................................................................. 138
4.2.1.4 Credit-risk-related contingent features ............................................................ 138
4.2.1.5 Credit derivatives ............................................................................................. 139
4.2.1.6 Additional disclosures for cash flow hedges ................................................... 140
4.2.1.7 Additional disclosures for embedded derivatives that are not separated ....... 141
4.2.1.8 Disclosures regarding statement of financial position offsetting ..................... 141
4.2.1.9 Additional disclosures for contracts in an entity’s own equity ......................... 142
4.2.1.10 Disclosures by not-for-profit organizations ...................................................... 142
Appendix A: Accounting Standards Updates mentioned in this guide .............................143
A.1 ASU 2018-12 .................................................................................................................................. 143
A.1.1 Overview........................................................................................................................... 143
A.1.2 Effective date and transition considerations ..................................................................... 143
A.2 ASU 2022-01 .................................................................................................................................. 143
A.2.1 Overview........................................................................................................................... 143
A.1.2 Effective date and transition considerations ..................................................................... 143
Appendix B: Acronyms, definitions and literature references...........................................145
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1. Introduction to derivatives and how they are accounted for

1.1 Overview
This guide is intended to provide a high-level overview of derivatives, including the accounting for them as
well as financial statement presentation and disclosure. ASC 815 provides the authoritative guidance for
derivatives and hedging. This guide is based primarily on the content within ASC 815-10 and ASC 815-15
and is composed of the following chapters:
• Chapter 1: Introduction to derivatives and how they are accounted for
• Chapter 2: Definition of a derivative and scope exceptions to derivative accounting
• Chapter 3: Embedded derivatives
• Chapter 4: Presentation and disclosure of derivatives and hedging activity
• Appendix A: Accounting Standards Updates mentioned in this guide
• Appendix B: Acronyms and literature references
Refer also to our companion guides:
• A guide to hedge accounting upon the adoption of ASU 2017-12, which is based on the content within
ASC 815-20, ASC 815-25, ASC 815-30 and ASC 815-35
• A guide to accounting for debt and equity instruments in financing transactions. Amongst other
provisions,
- Chapter 2 and 3 address the accounting for debt with conversion options and other embedded
features
- Chapter 4 addresses the accounting for preferred and similar stock (including embedded
derivatives within these instruments)
- Chapter 5 addresses the accounting for warrants and other equity-linked instruments and
includes an in-depth analysis of ASC 815-40 and the requirements for the derivative scope
exception for contracts in an entity’s own equity
• A guide to accounting for investments, loans and other receivables, which amongst other provisions,
addresses the accounting for contracts that are not derivatives and are within the scope of the Certain
Contract on Debt and Equity Securities subsection of ASC 815-10.
Derivatives and their related financial reporting considerations are complex. Reference should be made to
the appropriate subtopics within ASC 815 for a comprehensive understanding of the relevant guidance.
The following flow chart provides an overview of the accounting considerations that come into play when
determining if an instrument, contract or embedded feature requires recognition as a derivative, along
with references to sections within this guide where you can learn more about each consideration. As the
flow chart demonstrates, the application of the guidance in some respects differs depending on whether
the instrument is freestanding or embedded. Section 2.1.2 of Chapter 2 aids in making this determination.
Note that it is not necessary to adhere to the order in which the accounting considerations are outlined in
this flowchart. For example, rather than determining if an instrument, contract or feature is a derivative, it
may be more efficient to determine if it qualifies for a derivative scope exception, in which case whether it
is a derivative is a moot point. Similarly, when analyzing an embedded feature to determine if separate
recognition as a derivative is necessary, it may be more efficient to determine if the embedded feature
qualifies for a derivative scope exception or does not meet another criterion discussed in Chapter 3 to
require separate recognition as a derivative. (For example, an embedded feature that has economic

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characteristics and risks that are clearly and closely related to the host contract does not require separate
recognition as a derivative).

?
Is the instrument, contract or
Account for it in accordance with
embedded feature a No
other GAAP
derivative?

Yes

No
? Does it qualify for a derivative
scope exception?
Yes

No

?
Account for the
Is the derivative instrument
Freestanding instrument as a
embedded or freestanding?
derivative

Embedded

?
Does the embedded derivative
require separate recognition No
as a derivative?

Yes

Account for the embedded feature as

a derivative and account for the host
contract based on GAAP that is
applicable to an instrument of its type
that does not have an embedded
derivative

1.2 How are derivatives accounted for?

ASC 815-10-35 requires derivatives within its scope to be recognized at fair value on the statement of
financial position. The meaning of the term “derivative” herein refers to a financial instrument or contract
that meets the definition of a derivative pursuant to ASC 815 and not necessarily the colloquial definition
of a derivative. See Chapter 2 for the ASC 815 definition of a derivative. An exception to this exists under
the simplified approach that is discussed beginning at ASC 815-20-25-133, whereby certain private
companies can elect to recognize certain interest rate swaps at settlement value rather than fair value.
Derivatives are recognized as assets or liabilities, depending on their contractual rights or obligations.
Absent an election to apply hedge accounting, changes in the fair value of derivatives are recognized
through the statement of performance and can therefore cause significant earnings volatility from one
period to the next. Refer to A guide to hedge accounting upon the adoption of ASU 2017-12 for more
information on hedge accounting and the requirements that must be met to apply it. Refer also to

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Chapter 3 for additional considerations related to the accounting for an embedded derivative that has
been separately recognized and the host contract that remains after separation.
As noted in ASC 815-10-25-2 and 25-3, a contract (or a feature embedded in a contract) can move in and
out of derivative status. If a contract that was not by definition a derivative at the time it was acquired or
entered into later becomes a derivative that is within the scope of ASC 815, it would be immediately
recognized as a derivative asset or liability, at its fair value, with the initial offsetting entry and entries to
continuously adjust the carrying amount to fair value recognized through the statement of financial
performance. Conversely, if a contract that was accounted for as a derivative, ceases to be a derivative,
its carrying amount at that time becomes its cost basis and it would be accounted for prospectively based
on other GAAP relevant to the type of contract.

Select reasons why a contract or feature may move in and out of derivative status
• Conclusions reached on whether the net settlement characteristic of a derivative exists may
change. Specifically, as noted at Section 2.2.1.4.2 of Chapter 2, the evaluation of whether a market
mechanism exists and whether items to be delivered under a contract are readily convertible to
cash must be reassessed on an ongoing basis.
• The entity may newly qualify or no longer qualify for a scope exception. For example:
- To qualify for the nonfinancial asset or liability scope exception discussed at Section 2.3.5.2 of
Chapter 2 the underlying asset cannot be considered readily convertible to cash. Conclusions
reached in this regard can change from time to time as market activity changes.
- As discussed in Section 3.4.3 of Chapter 3, a change in circumstance may cause a feature that
qualified for the derivative scope exception in ASC 815-10-15-74(a) for contracts in an entity’s
own equity to no longer qualify or conversely, cause a feature that initially didn’t qualify for the
scope exception to newly qualify.
- As discussed in Section 2.3.2.3 of Chapter 2, a contract that initially qualified for the normal
purchases or normal sales scope exception may no longer qualify if physical delivery does not
remain probable.
• Modifications are made to the terms of the instrument or contract. As noted in Section 3.4.3 of
Chapter 3, a modification to a hybrid instrument could trigger the need to reassess conclusions
reached as to whether an embedded derivative is clearly and closely related to the host contract.
Additionally, changes to the terms may impact conclusions reached on whether a contract or
embedded feature is a derivative, and if so, whether it qualifies for a scope exception.

1.3 What is a derivative?

A derivative is a contract whose value is based on an underlying variable. That is, a derivative derives its
value from the fluctuation of a particular price (e.g., commodity price) or index (e.g., interest rate index) or
the occurrence or nonoccurrence of an event (e.g., hurricane). Derivative instruments come in various
forms and are designed to do various things. Certain derivatives may be designed to lock in the future
price of a commodity, such as steel. Other derivatives may be designed to speculate on future stock price
movements to attempt to make a profit. Still, others may be used to create a certain type of financing. For
example, an interest rate swap can effectively convert a variable interest rate to a fixed interest rate.
Entities may intentionally enter into derivatives for trading or investment purposes, or they may enter into
them to hedge a specific risk. It is important to understand that common contracts entities enter into may
be a derivative or contain an embedded derivative. As such, one has to be proactive in considering if a
contract or feature within a contract may be a derivative.

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A derivative instrument is defined as a financial instrument or other contract that has all of the following
characteristics:

Underlying Either notional Initial net investment Net settlement

amount
A variable that along The contract or May exist
with either a notional E.g., face amount, instrument requires no contractually, through
amount or a payment number of units or initial net investment a market mechanism
provision, determines currency, or or an initial net or delivery of a
the settlement of a Payment provision investment that is derivative instrument
derivative instrument. smaller than would be or an asset that is
A fixed or required for other
For example: determinable readily convertible to
types of contracts that cash (e.g., exchange
- A commodity price, settlement to be made would be expected to
if the underlying traded commodity or
interest rate, have a similar security).
exchange rate or behaves in a specified response to changes
related indices manner (E.g., a in market factors.
payment of $50,000
-The occurrence of a will be made if a
specified event (e.g., commodity index
IPO, change in reaches a specified
control) level).

Each of these characteristics are explored more fully in Chapter 2.

1.3.1 Why do entities use derivatives?
An entity can typically enter into a derivative contract with little or no money upfront and yet be exposed to
similar gains or losses as though they purchased the underlying asset at its market price. Consider the
following example that demonstrates this concept:
Investor A is interested in investing in shares of XYZ Company stock. It can purchase a share for $10 or
for $4 purchase an option contract that gives it the right to buy a share of XYZ at a price of $10 (i.e., the
strike price) over the next five years. (In this example, the option is said to be issued “at-the-money”
because its strike price is the same as the price of the underlying shares at the inception of the option). If
the share price increases in value by $5 during this five-year period, the option contract would experience
a similar increase in value even though its $4 purchase price was substantially less than the $10 price
Investor A would have incurred to purchase a share.
It is this characteristic that makes derivatives popular trading instruments. Interestingly, it is also what
makes derivatives valuable risk management tools. That is, an entity can take a trading position or
mitigate certain risks by entering into a derivative with little or no upfront money.
1.3.1.1 Using derivatives for trading purposes
Trading is defined in the ASC Master Glossary as “An activity involving securities sold in the near term
and held for only a short period of time. The term trading contemplates a holding period generally
measured in hours and days rather than months or years.” Because derivatives can change in fair value
relatively quickly, these instruments lend themselves to being used for trading purposes or speculative
purposes. For example, an entity may enter into a gold futures contract to purchase gold at a fixed price
with the hope that the price of gold will increase before the contract settles.
Derivatives can provide investors and traders a leveraged return. This means that even small changes in
the value of the underlying asset might result in disproportionately larger changes in value for the
derivative. That is, when an entity enters into a derivative, it is doing so in contemplation that slight
fluctuations in the derivative’s underlying will be amplified to produce a large return on investment. This is
illustrated through a continuation of the preceding example involving Investor A. Assume Investor A had

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$100 to invest and is considering either a direct investment in shares of XYZ or buying a five-year option
to purchase the same shares. The following comparison demonstrates how Investor A would have made
out upon the expiration of the option under both a $5 increase in share price and $5 decrease in share
price had it invested $100 to purchase 10 shares in XYZ at a price of $10 per share, or $100 to purchase
25 options at a price per option of $4.

Share Derivative option

Purchase price $10 per share $4 per option

Extended gain if share price

increases to $15 $50 ($5 x 10 shares) $125 ($5 x 25)

Extended loss if share price

decreases to $5 ($50) (-$5 x 10 shares) ($100) ($4 purchase price x 25)

1.3.1.2 Using derivatives for risk management purposes

An entity may enter into a derivative for risk management purposes. The following table further explains
three common risk management strategies whereby:
• Entity A hedges the variability of cash flows attributable to interest rate risk associated with the
floating-rate debt that it issued
• Entity B hedges the change in fair value attributable to interest rate risk associated with the fixed-rate
debt in which it invested
• Entity C hedges the variability of cash flows attributable to foreign currency risk associated with the
forecasted purchase of foreign currency-denominated inventory

Risk management Derivative used to

situation manage risk Risk management result

Entity A issued floating- Entity A enters into an Under the swap agreement, Entity A receives
rate debt whereby it interest rate swap with a interest payments based on the prime rate
pays an interest rate notional amount that and pays interest at a fixed rate of 3%. When
equal to prime plus 2%. equals the amount of its viewed in combination with its debt, the prime-
Entity A now decides variable rate debt whereby based portion of the interest payment that
that it no longer wants to it receives payments Entity A makes on the debt is offset by the
be subject to the based on prime and pays prime-based payment that it receives on the
potential variability a fixed interest rate of 3%, receive “leg” of the swap. In the aggregate,
attributable to applied to the notional Entity A pays interest at 5% (the 2% spread
fluctuations in the prime amount of the swap. above prime on the debt plus the 3% interest
rate. payment on the fixed leg of the swap). From
an aggregate economic perspective, the swap
converts the floating rate of interest on the
debt into a fixed rate. By implementing this
risk management strategy, Entity A has
eliminated the variability in its cash flows that
are attributable to changes in the prime rate.

Entity B invested in a Entity B enters into an Under the swap agreement, Entity B receives
fixed-rate debt security interest rate swap with a interest based on a Treasury rate and pays

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Risk management Derivative used to

situation manage risk Risk management result
that receives an interest notional amount that interest at a fixed rate of 5%. When viewed in
rate of 5%. Entity B equals the amount of the combination with the debt security, the 5%
realizes that if interest debt security whereby it interest payment that Entity B receives on its
rates increase, its receives payments based debt security is offset by the 5% interest it
investment would lose on a Treasury rate plus pays on the pay “leg” of the swap. Now, as
value because the 4% and pays a fixed rate interest rates (specifically Treasury) rise and
market would view the of 5%, with both rates fall, the interest rate Entity B receives on the
investment less applied to the notional Treasury “leg” of the swap adjusts
favorably than a higher amount of the swap. accordingly. By implementing this risk
interest-paying management strategy and thereby effectively
investment. converting the debt security from a fixed rate
to a variable rate, Entity B has protected itself
against the change in fair value of its debt
security that would otherwise be attributable
to changes in the Treasury rate.

Entity C, a U.S. dollar Entity C enters into a Regardless of how the USD moves compared
(USD) functional forward purchase contract to the CAD, three months from today, Entity C
currency entity forecasts to purchase CAD 125,000 will purchase CAD 125,000 for USD 100,000.
a purchase of inventory in three months at a price By implementing this risk management
that will be denominated of USD 100,000 agreed strategy, Entity C has protected itself against
in Canadian dollars upon today. the change in the USD/CAD exchange rate.
(CAD) three months
from today. The
forecasted purchase
price is CAD 125,000.
Entity C is concerned
that the CAD may
become more expensive
relative to the USD over
the next three months.

1.4 Hidden derivatives

In many cases, reporting entities don’t seek to enter into a derivative contract but rather are faced with a
requirement to account for what may have appeared to be an ordinary contract or embedded feature as a
derivative. A common example of an ordinary contract that may require derivative accounting is an option
contract that an entity enters into with its fuel supplier that enables it to buy stated quantities of fuel at a
stated price at future dates. A common example of an ordinary embedded feature that may require
derivative accounting is a provision within a debt agreement that requires immediate repayment of the
amount borrowed plus a premium in the event the obligor goes into default. Chapters 2 and 3 of this
guide aid in understanding what a derivative is and when they require derivative accounting treatment.

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1.5 How are derivatives transacted?

Broadly speaking, derivatives are transacted in one of the two following ways.

Exchange-traded Over the counter (OTC)

These derivatives are traded through mechanisms OTC derivative trades are negotiated and
referred to as exchanges and clearinghouses. executed between counterparties according to
Exchange-traded derivatives are standardized, their individual risk preferences. These private
which makes them more liquid and makes trading trades go through derivative dealers, who then
them more efficient. trade amongst themselves. Because these
transactions take place without a clearinghouse
When a derivative is traded on an exchange, a
standing between the two counterparties (as is the
clearinghouse stands between the two derivative
case in exchange-traded derivatives markets),
counterparties. Essentially, the clearinghouse
each counterparty is directly exposed to the credit
becomes the counterparty to each side of the
risk of the other counterparty. OTC derivative
trade. That is, rather than each party transacting
trades may or may not be subject to collateral
directly with each other, each party transacts with
requirements that when present, typically apply
the clearinghouse in a mirror trade. Exchange
only to the end-user and not to the dealer.
traded contracts generally require daily posting of
collateral to a margin account by the party that is OTC derivatives make up a greater portion of the
in a loss position to the contract on a given day. derivatives market.
An example of an exchange-traded derivative is a An example of an OTC derivative is a forward
futures contract that is described in the following contract that is described in the following table.
table.

1.6 Common types of derivative contracts

The following table discusses some common types of contracts that are derivatives if all the
characteristics of a derivative as discussed in Chapter 2 are met.

Type of contract Description Example

Forward contract A forward contract is a contract where A forward contract to sell 1,000 bushels
one party agrees to sell a financial of corn at $5 per bushel 90 days after
instrument, commodity, or some other inception of the contract.
asset to another party at a future date,
with the selling price established at the
inception of the contract.

Futures contract A futures contract is a forward contract A futures contract to buy 10 million
that is traded on an exchange. Futures BTUs of natural gas on the New York
contracts are standardized and Mercantile Exchange at $2.50 per
executed through a clearinghouse. million BTU to be delivered to a
standardized delivery point on the last
day of the month.

Interest rate An interest rate swap agreement is an Party A agrees to pay Party B an
swap arrangement between two interest rate of 1% per annum applied to
counterparties whereby each party a notional amount of $1 million and
agrees to be obligated to make a series Party B agrees to pay Party A a variable
of interest-based payments to the other interest rate per annum of one-month

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Type of contract Description Example

party, in exchange for the right to LIBOR also applied to a notional
receive a different series of interest- amount of $1 million. Payments on the
based payments from the other party. swap are due on the last business day
Most commonly, one party agrees to of the month, every month during its
pay a fixed rate in exchange for the term. On the payment date, if one-
receipt of a floating rate and vice versa, month LIBOR is less than 1%, Party A
which are commonly referred to as a will pay Party B the difference between
fixed-to-floating interest rate swap or a 1% and one-month LIBOR multiplied by
floating-to-fixed interest rate swap. $1 million multiplied by 30/360. If,
Swaps can also be structured to have however, one-month LIBOR is greater
payments exchanged based on two than 1%, Party B will pay Party A the
different floating rates (e.g., LIBOR, difference between one-month LIBOR
Prime), which is commonly referred to and 1% multiplied by $1 million
as a basis swap. The payments are multiplied by 30/360.
made on a net basis on contractual
settlement dates.

Currency swap Typically, under a currency swap, two On day 1, Party A pays USD 100,000 to
parties exchange an equal amount of Party B and Party B pays CAD 127,590
money in different currencies. to Party A. The contract is scheduled to
Essentially each party lends their settle in 90 days. Ninety days after
counterparty money in a given currency inception, the exchange rate has
and will repay that counterparty at a changed. Upon settlement, Party A
specified exchange rate on a specified pays CAD 127,590 (which it received on
date. At the end of the agreement, the day one) to Party B and Party B pays
parties will exchange currencies again USD 98,123 to Party A. Essentially,
to close out the contract at either the Party A lost USD 1,877 less the time
original exchange rate or a value of money. That is, while the
predetermined rate. amount of CAD that Party A received at
inception and paid at settlement was
the same (127,590), the amount of USD
that Party A received at settlement was
1,877 (100,000 – 98,123) less than the
amount it paid upon inception.

Commodity swap Under a commodity swap, each party Party A agrees to pay Party B $2.70 per
agrees to make a payment to the other mm BTU for natural gas and Party B
party that is based on a commodity agrees to pay Party A the current Henry
price or index applied to an agreed Hub rate for natural gas per mm BTU.
upon quantity or notional amount. Most The swap settles upon the last business
commonly one party agrees to pay a day of the month, every month for a
fixed price and the other party agrees to quantity of 10,000. On the settlement
pay a floating price. However, some date, if the Henry Hub rate for natural
commodity swaps involve the exchange gas is less than $2.70, Party A will pay
of floating payments that are based on Party B the difference between $2.70
one index for floating payments based and the Henry Hub rate for natural gas
on another index. On pre-defined per mm BTU multiplied by 10,000. If
however, the Henry Hub rate for natural
gas per mm BTU is greater than $2.70,

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JANUARY 2023

Type of contract Description Example

settlement dates, a payment exchanges Party B will pay Party A the difference
hands on a net basis. between the Henry Hub rate for natural
gas and $2.70 per mm BTU multiplied
by 10,000.

Call option A call option is a contract whereby the Entity XYZ purchased a call option from
holder of the contract has the right, but Entity ABC for $5. The call option gives
not the obligation, to purchase an asset Entity XYZ the right, but not the
from the call option writer at an agreed obligation, to buy equity shares of Entity
upon price referred to as the strike ABC from Entity ABC for $60. The
price. The strike price is typically fixed option expires in three years. Equity
at the inception of the contract. shares of Entity ABC were trading at
Depending on how the option is $50 per share upon the inception of the
structured, the holder may exercise its call option.
call option either at any time during the
In this example, Entity XYZ is
term of the option or upon a specified
considered the call purchaser or holder
date or dates.
and Entity ABC is considered the call
The holder of the call option is also writer or seller.
referred to as the purchaser. The writer
From Entity XYZ’s perspective, the call
of the call option is referred to as the
option is considered a purchased call;
seller.
and from Entity ABC’s perspective, the
The option contract is referred to as a call option is considered a written call.
purchased call from the perspective of
the holder and a written call from the
perspective of the writer.

Put option A put option is a contract whereby the Entity XYZ purchased a put option from
holder of the contract has the right, but Entity ABC for $5. The put option gives
not the obligation, to sell an asset to the Entity XYZ the right, but not the
put option writer at an agreed upon obligation, to sell equity shares of Entity
price referred to as the strike price. The ABC to Entity ABC for $50. The option
strike price is typically fixed at the expires in three years. Equity shares of
inception of the contract. Depending on Entity ABC were trading at $60 per
how the option is structured, the holder share upon the inception of the put
may exercise its put option either at any option.
time during the term of the option or
In this example, Entity XYZ is
upon a specified date or dates.
considered the put purchaser or holder
The holder of the put option is also and Entity ABC is considered the put
referred to as the purchaser. The writer writer or seller.
of the put option is referred to as the
From Entity XYZ’s perspective, the put
seller.
option is considered a purchased put;
The option contract is referred to as a and from Entity ABC’s perspective, the
purchased put from the perspective of put option is considered a written put.
the holder and a written put from the
perspective of the writer.

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JANUARY 2023

Type of contract Description Example

Collar A combination of a put option and call Entity XYZ purchases equity shares of
option. Entity MNO for $50 per share and
enters into a collar such that it will only
be exposed to price changes between
$45 and $55 per share.
Specifically, Entity XYZ writes a call
option to Entity ABC whereby Entity
ABC can call equity shares of Entity
MNO from Entity XYZ for $55 per share.
Simultaneously, Entity XYZ purchases a
put option from Entity ABC whereby
Entity XYZ can put equity shares of
Entity MNO to Entity ABC for $45 per
share.
If the price of Entity MNO’s equity
shares increases above $55 per share,
Entity XYZ’s written call will be in a loss
position to Entity XYZ to the degree to
which the price of the shares exceeds
$55 per share. This loss will offset the
gain position Entity XYZ experiences
due to the price increase on the shares
of Entity MNO it holds that were
purchased at $50 per share.
Alternatively, if the price of Entity MNO
equity shares decreases below $45 per
share, Entity XYZ’s purchased put
option will be in a gain position to Entity
XYZ to the degree to which the price of
the shares is below $45 per share. This
will offset the loss Entity XYZ incurs due
to the price decrease on the shares of
Entity MNO it holds that were
purchased at $50 per share. As a result,
Entity XYZ is only exposed to price
changes between $45 and $55, which
forms the “collar.”

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JANUARY 2023

2. The scope of ASC 815 and the determination of what is a derivative

2.1 Scope of ASC 815
ASC 815 applies to all entities and to all financial instruments and other contracts that meet the definition
of a derivative in ASC 815-10-15-83 and do not qualify for one of the many scope exceptions discussed in
Section 2.3 of this chapter.
2.1.1 Unit of account for scope purposes
ASC 815-10-15-4A through 15-9 address certain unit of account questions that determine how the
guidance in ASC 815 is applied. The questions addressed are whether:
• A contract should be viewed as freestanding or embedded because if embedded, there are additional
conditions in ASC 815-15-25-1 that must be met to recognize an embedded feature as a derivative
(Refer to Chapter 3 for a summary of this analysis).
• Two or more contracts should be viewed as a unit when applying the guidance in ASC 815-10.
2.1.2 Freestanding or embedded
A freestanding financial instrument is defined in the master glossary as:
A financial instrument that meets either of the following conditions:
a. It is entered into separately and apart from any of the entity’s other financial instruments or equity
transactions.
b. It is entered into in conjunction with some other transaction and is legally detachable and
separately exercisable.
This concept that a freestanding instrument is legally detachable is reinforced in ASC 815-10-15-5, which
indicates a feature that may be sold or traded separately from the contract in which it is embedded is an
attached freestanding derivative rather than an embedded derivative by both the writer and the holder (if
the feature meets the definition of a derivative).
As explained in ASC 815-10-15-6, if a third party attaches a put or call option to a debt instrument
contemporaneously with or after the issuance of that debt instrument, it is viewed as a separate
freestanding instrument from the debt instrument rather than embedded in the debt instrument because
the option and debt have different counterparties. Pursuant to ASC 815-15-25-2, an embedded derivative
refers to a feature embedded within a single contract rather than features in separate contracts between
different counterparties.
As explained in ASC 815-10-15-7, if at its issuance, a debt instrument includes an option feature that is
explicitly transferable separate from the debt instrument; and as a result, could be exercised by a party
other than the issuer or investor of the debt instrument, that option should be considered an attached
freestanding derivative, and not an embedded derivative, by the option writer and the holder.
2.1.3 Viewing multiple contracts as a unit
As indicated in ASC 815-10-15-8, an entity may enter into two or more transactions that together would
create an economic result that is similar to that of a single transaction that would be required to be
accounted for as a derivative. To prevent an entity from attempting to circumvent the derivative
accounting requirements, ASC 815-10-15-9 requires two or more separate transactions to be viewed as
one unit of account if the following indicators are present:
• The transactions were entered into contemporaneously and in contemplation of each other.
• The transactions were executed with the same counterparty (or structured through an
intermediary).

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JANUARY 2023

• The transactions relate to the same risk.

• There is no apparent economic need or substantive business purpose for structuring the
transactions separately that could not also have been accomplished in a single transaction.
ASC 815 requires that the indicators be assessed in the aggregate. The following example illustrates the
application of this guidance in the context of two commodities forward contracts.

Example 2.1.1: Recognition—Viewing Separate Transactions as a Unit for Purposes of

Evaluating Net Settlement
Case A: Two Forward Contracts Viewed as a Unit (from ASC 815-10-55-177 to 55-178)
Entity A enters into a forward contract to purchase 1,500,000 units of a particular commodity in 3
months for $10 per unit. Simultaneously, Entity A enters into a forward contract to sell 1,400,000
units of the same commodity in 3 months for $10 per unit. The purchase and sale contracts are with
the same counterparty. There is no market mechanism to facilitate net settlement of the contracts,
and both contracts require physical delivery of the commodity at the same location in exchange for
the forward price. On a gross basis, neither contract is readily convertible to cash because the
market cannot rapidly absorb the specified quantities without significantly affecting the price.
However, on a net basis, Entity A has a forward purchase contract for 100,000 units of the
commodity, a quantity that can be rapidly absorbed by the market and thus is readily convertible to
cash.
In this Case, it appears that there is no clear business purpose for structuring the transactions
separately. Therefore, the facts point to the conclusion that the purchase and sale were done as a
structured transaction with one counterparty to circumvent the definition of a derivative instrument
under this Subtopic. However, if the facts indicated that both contracts required physical delivery of
the commodity at different locations that are significantly distant from one another and each
counterparty is expected to deliver the gross amount of the commodity to the other, those facts may
reflect a valid substantive business purpose for the transaction.

Examples from ASC 815-10-55 follow to demonstrate the application of this guidance in the context of
interest rate swaps and lending transactions.

Example 2.1.2: Recognition—Viewing Separate Transactions as a Unit (from ASC 815-10-55-171

to 55-174)
The following Cases illustrate when separate transactions should be viewed as a unit:
a. Swaps that should be viewed as a unit (Case A)
b. Swaps that should not be viewed as a unit (Case B).
In Cases A and B, an entity that is the issuer of fixed-rate debt enters into an interest rate swap
(Swap 1) and designates it as a hedge of the fair value exposure of the debt to interest rate risk.
The fair value hedge of the fixed-rate debt involving Swap 1 meets the required criteria in Section
815-20-25 to qualify for hedge accounting. The entity simultaneously enters into a second interest
rate swap (Swap 2) with the same counterparty with the exact mirror terms as Swap 1 and does not
designate Swap 2 as part of that hedging relationship.
Case A: Swaps that Should Be Viewed as a Unit
If Swap 2 was entered into in contemplation of Swap 1 and the overall transaction was executed for
the sole purpose of obtaining fair value accounting treatment for the debt, it should be concluded
that the purpose of the transaction was not to enter into a bona fide hedging relationship involving
Swap 1. In that instance, the two swaps should be viewed as a unit and the entity would not be

12
JANUARY 2023

permitted to adjust the carrying value of the debt to reflect changes in fair value attributable to
interest rate risk.
Case B: Swaps that Should Not Be Viewed as a Unit
If Swap 2 was not entered into in contemplation of Swap 1 or there is a substantive business
purpose for structuring the transactions separately, and if both Swap 1 and Swap 2 were entered
into in arm’s-length transactions (that is, at market rates), then the swaps should not be viewed as a
unit. For example, some entities have a policy that requires a centralized dealer subsidiary to enter
into third-party derivative contracts on behalf of other subsidiaries within the entity to hedge the
subsidiaries’ interest rate risk exposures. The dealer subsidiary also enters into internal derivative
contracts with those subsidiaries to operationally track those hedges within the entity. (As discussed
beginning in paragraph 815-20-25-61, internal derivatives do not qualify in consolidated financial
statements as hedging instruments for risks other than foreign exchange risk.)

RSM commentary: It is relatively common for lending institutions to enter into interest rate swap
agreements with their loan customers (so that the customer can convert a variable rate loan to a fixed
rate) and contemporaneously enter into an interest rate swap with a dealer that has terms that mirror
the interest rate swap the lender entered into with its loan customer. The interest rate swaps in this
scenario are viewed as two separate swaps (rather than one unit netted together) because each swap
is with a different counterparty. Additionally, there is a substantive business purpose for structuring the
transactions this way in that the lender desires a variable rate loan and its customer desires a fixed rate
loan. The mirror swaps are a vehicle to accomplish the opposite objectives of the lender and its
customer.

Example 2.1.3: Borrowing and Lending Transactions Viewed as a Unit (from ASC 815-10-55-179
to 55-180)
Entity C loans $100 to Entity B. The loan has a 5-year bullet maturity and an 8 percent fixed interest
rate, payable semiannually. Entity B simultaneously loans $100 to Entity C. The loan has a five-year
bullet maturity and a variable interest of LIBOR, payable semiannually and reset semiannually.
Entity B and Entity C enter into a netting arrangement that permits each party to offset its rights and
obligations under the agreements. The netting arrangement meets the criteria for offsetting in
Subtopic 210-20. The net effect of offsetting the contracts for both Entity B and Entity C is the
economic equivalent of an interest rate swap arrangement, that is, one party receives a fixed
interest rate from, and pays a variable interest rate to, the other.
In this Case, based on the facts presented, there is no clear business purpose for the separate
transactions, and they should be accounted for as an interest rate swap under this Subtopic.
However, in other instances, a clear substantive business purpose for entering into two separate
loan transactions may exist (for example, as a means to overcome foreign currency expatriation
restrictions).

RSM commentary: Typically, it is not difficult to determine whether two or more transactions related to
the same risk were entered into contemporaneously and with the same counterparty. As a result, the
key determining factor as to whether an entity should view two or more transactions as one unit of
account often is whether there is a substantive business purpose for structuring the transactions
separately.

Whereas ASC 815-10-15-9 sets forth the indicators that an entity should consider to determine whether
individual nonderivative contracts or transactions should be viewed as one unit of account for purposes of
concluding if that unit of account is a derivative within the scope of ASC 815. ASC 815-10-25-6 addresses
whether an entity should consider two derivative contracts that are within the scope of ASC 815 as one

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unit of account for recognition and other purposes by providing indicators that are essentially the same as
those in ASC 815-10-15-9.
Often multiple embedded derivatives (i.e., derivative features that are contained within a nonderivative
contract) are found in a single contract. An example is a convertible debt instrument that has multiple
scenarios under which the holder could elect to convert the debt into common stock. In cases like this, the
multiple embedded derivatives are analyzed to determine the unit of account, namely whether an entity
should analyze each embedded feature individually or in combination with another feature or features
when performing the analysis to determine if derivative recognition is necessary for any or all of the
embedded features within the contract. Refer to Chapter 3 for more information about the accounting
analysis for embedded derivatives.
As it relates to put and call options, ASC 815-10-25-7 to 25-13 provide guidance on whether an entity
should account for combinations of put and call option contracts separately or as a single forward contract
when those options have the same key terms and neither option is required to be exercised. Generally, if
at least one of the options is freestanding and transferable from the other, each of the options would be
viewed as separate units of account. Conversely, if both of the options are embedded in a single contract
and have the same terms, it may be appropriate to view them as a single forward contract. ASC 815-10-
55-3 and the examples that begin in ASC 815-10-55-66 reinforce the concept that if a put or call option
can be transferred to a third party, they are viewed as a separate unit of account from the bond or other
instrument to which they relate.
2.2 The determination of what is a derivative within the scope of ASC 815
The FASB originally considered developing a list of instruments that are typically thought of as derivatives
to form the scope of ASC 815. However, the FASB recognized that over time, such a list would likely
become outdated. As a result, the FASB created a definition of a derivative supplemented with a list of
scope exceptions. In other words, an instrument that by definition is a derivative is within the scope of
ASC 815 unless it qualifies for a scope exception discussed in Section 2.3 of this chapter.
2.2.1 Definition of derivative instrument
The following definition of a derivative is provided in ASC 815-10-15-83.
A derivative instrument is a financial instrument or other contract with all of the following
characteristics:
a. 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:
1. One or more underlyings
2. One or more notional amounts or payment provisions or both.
b. 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.
c. Net settlement. The contract can be settled net by any of the following means:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. It provides for delivery of an asset that puts the recipient in a position not substantially
different from net settlement.
As indicated in ASC 815-10-15-3, a contract that does not qualify as a derivative upon its initial
recognition may subsequently meet the definition of a derivative, at which time it should be accounted for

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as a derivative instrument. Because of this, certain contracts may need to be continually assessed to
ensure that they are accounted for properly. See Chapter 1 for an introduction on how to account for
derivatives.
Each of the characteristics of a derivative instrument are explained in further detail in the following
subsections.
2.2.1.1 Underlying
For a financial instrument or contract to meet the definition of a derivative, it must contain an underlying,
which is defined in ASC 815-10-15-88 as follows:
An underlying is a variable that, along with either a notional amount or a payment provision,
determines the settlement of a derivative instrument. An underlying usually is one or a combination of
the following:
a. A security price or security price index
b. A commodity price or commodity price index
c. An interest rate or interest rate index
d. A credit rating or credit index
e. An exchange rate or exchange rate index
f. An insurance index or catastrophe loss index
g. A climatic or geological condition (such as temperature, earthquake severity, or rainfall), another
physical variable, or a related index
h. The occurrence or nonoccurrence of a specified event (such as a scheduled payment under a
contract)
An underlying is a variable that can be a price, rate or index associated with an asset or liability, but it is
not the asset or liability itself. For example, the price of a commodity is an underlying, but the commodity
itself is not.
An underlying is a key characteristic of a derivative. Generally, when the underlying fluctuates, the fair
value of the derivative changes. For example, as the price of cocoa fluctuates, the fair value of a cocoa
forward contract will increase or decrease resulting in a corresponding gain or loss. This is because
derivatives such as forwards, futures, and options typically specify a price or rate related to the underlying
asset that is fixed. As a result, as the market price or rate changes, the derivative becomes more or less
valuable due to its fixed-settlement price. For example, assume Entity A agrees to buy a commodity for
$50 per unit in 90 days. If the fair value of the commodity is $59 per unit when the contract settles on the
90th day, Entity A will close out the contract with a $9 gain per unit. In this example, the upward
movement of the underlying price away from the fixed-purchase price of $50 per unit created the $9 gain
per unit. However, if Entity A instead agreed to buy the same commodity in 90 days at the then fair value,
Entity A would have paid $59 per unit for the commodity at settlement, which would have resulted in no
gain or loss. Therefore, although a contract that will settle at the then fair value contains an underlying
and may meet the definition of a derivative, its fair value will typically be zero at all times.
As indicated in ASC 815-10-15-89, an underlying can be any variable whose changes can be observed or
objectively verified. Therefore, the occurrence or nonoccurrence of an event qualifies as an underlying. A
contract contains an underlying if it requires payment only if certain conditions are met (e.g., Party A is
required to pay Party B if the S&P 500 index increases by a stated amount). In such cases, a change in
the likelihood of the event occurring changes the fair value of the derivative.
A financial instrument or other contract that does not contain an underlying does not meet the definition of
a derivative.

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Examples of determining an underlying in contracts that are comprised of a fixed price component, a
variable price component and a combination thereof are provided in ASC 815-10-55-77 to 55-83.
2.2.1.2 Notional amount or payment provision
For a financial instrument or contract to meet the definition of a derivative, it must contain either a notional
amount or payment provision, which are defined in ASC 815-10-15-92 and 15-93, respectively:
Notional Amount
A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in
the contract. Other names are used, for example, the notional amount is called a face amount in some
contracts. The settlement of a derivative instrument with a notional amount is determined by interaction
of that notional amount with the underlying. The interaction may be simple multiplication, or it may
involve a formula with leverage factors or other constants. As defined in the glossary, the effective
notional amount is the stated notional amount adjusted for any leverage factor. If a requirements
contract contains explicit provisions that support the calculation of a determinable amount reflecting the
buyer’s needs, then that contract has a notional amount. See paragraphs 815-10-55-5 through 55-7 for
related implementation guidance. For implementation guidance on identifying a commodity contract’s
notional amount, see paragraph 815-10-55-5.
Payment provision
As defined in the glossary, a payment provision specifies a fixed or determinable settlement to be
made if the underlying behaves in a specified manner. For example, a derivative instrument might
require a specified payment if a referenced interest rate increases by 300 basis points.
As discussed, an underlying is a variable associated with a derivative. The notional amount is the quantity
specified in the derivative contract. The interaction of the underlying and notional amount of a derivative,
which may be simple multiplication or involve a leverage factor, determines its settlement amount.
Similarly, a fixed or determinable payment provision based on the behavior of a specified underlying also
determines the settlement amount of a derivative contract. The following are examples of underlyings,
notional amounts, and payment provisions found in common derivative financial instruments.

Derivative Underlying Notional amount Payment provision

Interest rate swap One-month LIBOR $10,000,000 N/A

where one party is
owed payments based
on 1% per annum on
$10,000,000 and the
counterparty is owed
payments based on
one-month LIBOR on
$10,000,000

Forward contract to USD/Euro exchange $1,000,000 N/A

purchase $1,000,000 rate
for 860,000 Euros

Futures contract traded Price of CBOT wheat 5,000 bushels N/A

on the Chicago Board
of Trade (CBOT) to buy
5,000 bushels of wheat

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Derivative Underlying Notional amount Payment provision

Option to buy 100 Price of Entity A’s 100 shares N/A

shares of common common stock
stock of Entity A

Contract to pay The occurrence of N/A Payment amount of

$500,000 if Entity A’s Entity A’s stock price $500,000
stock price falls below falling below $75
$75

A financial instrument or other contract that does not contain both an underlying and either a notional
amount or payment provision does not meet the definition of a derivative.
2.2.1.2.1 Determining the notional amount in requirements contracts
Unlike a typical commodity contract that specifies a fixed number of units to be bought (sold), certain
contracts commonly referred to as requirements contracts, require a seller to supply the amount of units
that the purchaser will need during a certain period of time for purposes other than resale. Determining
whether a requirements contract contains a notional amount requires careful analysis of the contractual
arrangements between the parties.
To conclude that a requirements contract contains a notional amount, there must be a reliable means to
determine the quantity that will be required to be bought (sold). If there is not a reliable way to determine
a quantity, the contract does not contain a notional amount.
Generally, the seller of a particular commodity would understand the buyer’s needs for that commodity
because the expected quantity influences pricing. Additionally, without such an understanding, the seller
may not be able to determine if it can meet the buyer’s needs. As a result, those needs are often
quantified in either the requirements contract itself or its related attachments or side agreements. Thus,
an entity should consider the full set of documents between the parties when determining if there are
terms that support a determinable quantity such that the contract has a notional amount.
The default provisions of a requirements contract may provide a way of determining the quantity of a
contract; and thus, its notional amount. ASC 815-10-55-7 in part provides guidance on analyzing the
default provisions of a requirements contract.
Often the default provisions of requirements contracts will specifically refer to anticipated quantities to
utilize in the calculation of penalty amounts in the event of nonperformance. Other default provisions
stipulate penalty amounts in the event of nonperformance based on average historical usage quantities
of the buyer. If those amounts are determinable, they shall be considered the notional amount of the
requirements contract.
Some requirements contracts specify minimum and (or) maximum quantities of units to be bought (sold),
in which case, determining the notional amount can be more complicated. The notional amount of a
requirements contract cannot exceed any stated maximum in the contract or its related side agreements.
Also, the notional amount of a requirements contract cannot be less than any stated minimum in the
contract or its related side agreements.
The following table indicates the quantity that would be considered the notional amount based on whether
a requirements contract specifies a minimum and (or) maximum quantity and whether there is an
otherwise determinable quantity.

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Otherwise
Minimum quantity Maximum quantity determinable quantity
specified specified (see Note) Notional amount

Yes No Less than the minimum Minimum quantity

Yes No Greater than the Otherwise determinable

minimum quantity

Yes No Not determinable Minimum quantity

No Yes Less than the Otherwise determinable

maximum quantity

No Yes Greater than the Maximum quantity

maximum

No Yes Not determinable Not determinable

Yes Yes Less than the minimum Minimum quantity

Yes Yes More than the minimum Otherwise determinable

and less than the quantity
maximum

Yes Yes More than the Maximum quantity

maximum

Yes Yes Not determinable Minimum quantity

Note: The otherwise determinable quantity refers to the quantity that is reliably determinable from the
requirements contract and (or) related side agreements other than any contractually specified minimum or
maximum quantity.

An entity is required to determine the notional amount of a requirements contract over the term of the
contract. Consequently, the notional amount may change over time, which could happen for example if
the notional amount was based on default provisions that refer to a rolling average historical usage.
The following are four examples of how to determine the notional amount of a requirements contract.

Example 2.2.1: Identifying a commodity contract’s notional amount (from ASC 815-10-55-5 to
55-7)
Many commodity contracts specify a fixed number of units of a commodity to be bought or sold
under the pricing terms of the contract (for example, a fixed price). However, some contracts do not
specify a fixed number of units. For example, consider the following four contracts that require one
party to buy the following indicated quantities:
a. Contract 1: As many units as required to satisfy its actual needs (that is, to be used or
consumed) for the commodity during the period of the contract (a requirements contract). The
party is not permitted to buy more than its actual needs (for example, the party cannot buy
excess units for resale).

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b. Contract 2: Only as many units as needed to satisfy its actual needs up to a maximum of 100
units. The party is not permitted to buy more than its actual needs (for example, the party
cannot buy excess units for resale).
c. Contract 3: A minimum of 60 units and as many units needed to satisfy its actual needs in
excess of 60 units. The party is not permitted to buy more than its actual needs (for example,
the party cannot buy excess units for resale).
d. Contract 4: A minimum of 60 units and as many units needed to satisfy its actual needs in
excess of 60 units up to a maximum of 100 units. The party is not permitted to buy more than
its actual needs (for example, the party cannot buy excess units for resale).
Generally, the anticipated number of units covered by a requirements contract is equal to the
buyer’s needs. When a requirements contract is negotiated between the seller and buyer, both
parties typically have the same general understanding of the buyer’s estimated needs. Given the
buyer’s often exclusive reliance on the seller to supply all its needs of the commodity, it is imperative
from the buyer’s perspective that the supplier be knowledgeable with respect to anticipated
volumes.
This guidance focuses solely on whether the contracts under consideration have a notional amount
pursuant to the definition in this Subtopic. These types of contracts may not satisfy certain of the
other required criteria in this Subtopic for them to meet the definition of a derivative instrument. The
conclusion that a requirements contract has a notional amount as defined in this Subtopic can be
reached only if a reliable means to determine such a quantity exists.
a. Contract 1—requirements contract. The identification of a requirements contract’s notional
amount may require the consideration of volumes or formulas contained in attachments or
appendixes to the contract or other legally binding side agreements. The determination of a
requirements contract’s notional amount must be performed over the life of the contract and
could result in the fluctuation of the notional amount if, for instance, the default provisions
reference a rolling cumulative average of historical usage. If the notional amount is not
determinable, making the quantification of such an amount highly subjective and relatively
unreliable (for example, if a contract does not contain settlement and default provisions that
explicitly reference quantities or provide a formula based on historical usage), such contracts
are considered not to contain a notional amount as that term is used in this Subtopic. One
technique to quantify and validate the notional amount in a requirements contract is to base the
estimated volumes on the contract’s settlement and default provisions. Often the default
provisions of requirements contracts will specifically refer to anticipated quantities to utilize in
the calculation of penalty amounts in the event of nonperformance. Other default provisions
stipulate penalty amounts in the event of nonperformance based on average historical usage
quantities of the buyer. If those amounts are determinable, they shall be considered the
notional amount of the contract.
b. Contract 2—requirements contract with a specified maximum quantity. Whether the contract
has a notional amount depends. The same considerations discussed in (a) with respect to
Contract 1 also apply to Contract 2; however, the notional amount cannot exceed 100 units.
c. Contract 3—requirements contract with a specified minimum quantity. The contract has a
notional amount. The same considerations discussed in (a) with respect to Contract 1 also
apply to Contract 3; however, the notional amount of Contract 3 cannot be less than 60 units. A
contract that specifies a minimum number of units always has a notional amount at least equal
to the required minimum number of units. Only that portion of the requirements contract with a
determinable notional amount would be accounted for as a derivative instrument under this
Subtopic.
d. Contract 4—requirements contract with a specified maximum and minimum quantities. The
contract has a notional amount. The same considerations discussed in (a) with respect to
Contract 1 also apply to Contract 4; however, the notional amount of Contract 4 cannot be less
than 60 units or greater than 100 units. A contract that specifies a minimum number of units

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always has a notional amount at least equal to the required minimum number of units. Only that
portion of the requirements contract with a determinable notional amount would be accounted
for as a derivative instrument under this Subtopic.

2.2.1.3 Initial net investment

For a financial instrument or contract to meet the definition of a derivative, it must require 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. Although guidance on the initial net investment
characteristic of a derivative is written from the perspective of one party (i.e., the party that is making the
initial net investment), the determination of whether this characteristic is met applies to both parties of a
potential derivative instrument as noted in ASC 815-10-15-98.
The reason why derivatives often require no, or little initial net investment is because a derivative reflects
an investment in a change in value resulting from a change in an underlying, rather than an investment in
the item associated with the underlying.
For example, if an investor wishes to have the exposure to the risks and rewards of owning gold over a
period of time without an initial capital outlay and the inconvenience of having to store the gold, rather
than purchasing gold upfront, the investor could enter into a forward contract to purchase gold at a date in
the future for a price that is fixed at the inception of the contract. For example, if the forward contract price
was fixed at $1,700 per ounce and the fair value of the gold was $1,790 per ounce at contract settlement,
the investor would have a $90 gain per ounce upon settlement. As a result, the investor would have
benefited during the term of the contract from the change in the price of gold without having owned the
gold or making an initial net investment. As another example, if an investor wishes to participate in the
potential upside of the common stock in Entity A with limited downside risk, the investor could purchase a
call option on the common stock of Entity A. The investor would pay a small (relative to the price of the
stock) premium and would obtain the right, but not the obligation to buy common stock of Entity A at a
stated price within a stated period of time. For example, when Entity A’s stock is trading around $70, the
investor may pay around $20 to purchase an option with a 10-year term that gives it the right to purchase
a share of Entity A’s stock at an exercise price of $70 per share during that term. As the fair value of the
common stock increases, the investor will experience similar gains on the option despite its initial net
investment being small relative to the price of the common stock at the time it purchased the option.
Further general information about the size of the initial net investment of a derivative as well as examples
of an initial net investment of a derivative are provided in ASC 815-10-15-95.
A derivative instrument does not require an initial net investment in the contract that is equal to the
notional amount (or the notional amount plus a premium or minus a discount) or that is determined by
applying the notional amount to the underlying. For example:
a. A commodity futures contract generally requires no net investment, while purchasing the same
commodity requires an initial net investment equal to its market price. However, both contracts
reflect changes in the price of the commodity in the same way (that is, similar gains or losses will
be incurred).
b. A swap or forward contract generally does not require an initial net investment unless the terms
favor one party over the other.
c. An option generally requires that one party make an initial net investment (a premium) because
that party has the rights under the contract and the other party has the obligations.
Further information on derivatives that require an initial net investment as compensation is provided in
ASC 815-10-15-94.
Many derivative instruments require no initial net investment. Some require an initial net investment as
compensation for one or both of the following:

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a. Time value (for example, a premium on an option)

b. Terms that are more or less favorable than market conditions (for example, a premium on a
forward purchase contract with a price less than the current forward price).
Others require a mutual exchange of currencies or other assets at inception, in which case the net
investment is the difference in the fair values of the assets exchanged.
As indicated in ASC 815-10-15-94, a derivative may require an initial net investment to pay for off-market
terms such as an upfront payment on an interest rate swap because the swap terms are more favorable
than the current market rate. The size of the upfront payment determines whether the initial net
investment characteristic in ASC 815-10-15-83(b) exists.
Some derivatives require a mutual exchange of currencies or other assets, potentially at the inception and
maturity of the derivative. In such instances, the initial net investment would be considered the difference
between the fair values of the currencies or assets exchanged at inception. For example, if at the
inception of a currency swap, the two parties exchange currencies of equal fair values, this results in an
initial net investment of zero. As noted in ASC 815-10-55-8, such a currency swap is a derivative if it
obligates the two parties to the transaction to exchange specified currencies on specified dates at
specified prices.
General guidance on meeting the initial net investment characteristic is addressed in ASC 815-10-15-96
to 15-97.
If the initial net investment in the contract (after adjustment for the time value of money) is less, by
more than a nominal amount, than the initial net investment that would be commensurate with the
amount that would be exchanged either to acquire the asset related to the underlying or to incur the
obligation related to the underlying, the characteristic in paragraph 815-10-15-83(b) exists. The amount
of that asset acquired or liability incurred should be comparable to the effective notional amount of the
contract. This does not imply that a slightly off-market contract cannot be a derivative instrument in its
entirety. That determination is a matter of facts and circumstances and shall be evaluated on a case-
by-case basis. Example 16, Case C (see paragraph 815-10-15-166) illustrates this guidance in this
paragraph.
A contract that requires an initial net investment in the contract that is in excess of the amount
determined by applying the effective notional amount to the underlying is not a derivative instrument in
its entirety. Example 16, Case A (see paragraph 815-10-55-150) illustrates such a contract.
ASC 815 does not precisely define what is meant by “less, by more than a nominal amount.” However,
the FASB did provide an example comprised of three cases of prepaid interest rate swaps in ASC 815-
10-55-148 to 55-168 that provide insight into the concept.
The following table summarizes the three cases.

Case A Case B Case C

Term 2 years 2 years 2 years

Notional amount $10,000,000 $10,000,000 $10,000,000

Settlement Quarterly Quarterly Quarterly

Variable-rate 3-month LIBOR 3-month LIBOR 3-month LIBOR

plus 300 bps minus 100 bps

Fixed-rate 6.65% 9.65% 5.65%

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Case A Case B Case C

Initial net investment (Note 1) $1,228,179 $1,782,245 $1,043,490

Commensurate initial net investment

(Note 2) $1,228,179 $1,228,179 $1,228,179

The initial net investment characteristic No No Yes

of a derivative is met

Note 1: The initial net investment is the amount that is prepaid, which for each case mirrors the sum of the present
values of the eight fixed-rate quarterly payments. The quarterly payments of each interest rate swap are determined
by multiplying the notional amount of the swap by its annual fixed rate divided by four (being that the settlements
are quarterly). The initial net investment is different in each case because the fixed interest rate is different in each
case.
Note 2: The commensurate initial net investment is the initial net investment that would be commensurate with the
amount that would be exchanged to acquire the asset related to the underlying (i.e., the 3-month LIBOR rate). The
commensurate initial net investment is determined by summing the present value of the 3-month LIBOR portion of
the eight variable-rate quarterly payments, excluding any interest spread. Only the 3-month LIBOR portion is used
because 3-month LIBOR is the underlying. The quarterly payments are determined by multiplying the swap’s
notional amount by the annual 3-month LIBOR swap rate in effect at the inception of the swap of 6.65% divided by
four (being that the settlements are quarterly). Because the underlying (3-month LIBOR) is the same in each case,
the commensurate initial net investment is the same in each case.
In Case A (the base case), the rate on the variable rate leg of the swap is 3-month LIBOR. The forward 3-
month LIBOR rate curve in this example is 6.65%, which is why the rate on the fixed-rate leg of the swap
in Case A is 6.65%. The terms of the swap in Case B and Case C are the same as Case A except that for
Case B, there is a 300 basis point (i.e., 3%) positive spread included in the rate for each leg of the swap
and for Case C, a 100 basis point spread is subtracted from the rate for each leg of the swap.
In each of the three cases, the fixed-rate payer prepaid the present value of all of the fixed-rate payments
under the interest rate swap agreement. The amount of the prepayment is considered its initial net
investment and needs to be assessed to determine if it is less than the commensurate initial net
investment by more than a nominal amount.
In Case A, the initial net investment of the swap is the same as the commensurate initial net investment.
In Case B, the initial net investment of the swap is greater than the commensurate initial net investment.
This means that the prepaid interest rate swaps in Case A and Case B do not have the initial net
investment characteristic of a derivative because their initial net investments are not smaller than the
commensurate initial net investment. As a result, the prepaid interest rate swaps in Case A and Case B
are not considered derivatives in their entirety pursuant to ASC 815. However, in Case C, the initial net
investment of the swap is approximately 15% less than the commensurate initial net investment. The
FASB concluded that in Case C, the initial net investment of the swap is less than, by more than a
nominal amount the initial net investment that would be commensurate with the amount that would be
exchanged to acquire an asset that is associated with the underlying, i.e., the 3-month LIBOR.
The guidance in ASC 815-10-55-168 makes clear that Case C was not meant to make a distinction
between a “nominal amount” and “more than a nominal amount.” That paragraph also indicates that a
percentage less than 15% could also be considered more than a nominal amount. In practice, we have
observed that 10% is generally considered to be more than a nominal amount for purposes of assessing
the initial net investment characteristic of a derivative.

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Although the prepaid interest rate swaps in Case A and Case B are not derivatives in their entirety, they
each contain an embedded interest rate swap that needs to be separately recognized as a derivative
unless the entire instrument is accounted for at fair value through earnings as elaborated on at 815-10-
55-158 to 163. Embedded derivatives are discussed more fully in Chapter 3 of this guide.

Determining the initial net investment when a derivative (e.g., interest rate swap) is modified
It is not uncommon for entities to modify the terms of outstanding interest rate swaps for reasons that
may include a desire to extend the maturity date (referred to as a “blend and extend” transaction) or to
better align the terms of the swap with the debt it may be hedging. In addition, an entity may wish to
modify an interest rate swap to essentially refinance to obtain a preferential interest rate. When a
critical term or terms of a derivative is modified, that is generally viewed as a termination of the original
derivative and the issuance of a new derivative. As such, at the time of the modification, it is generally
necessary to do an analysis like what is illustrated in the aforementioned prepaid interest rate swap
examples to determine whether or not the new interest rate swap is a derivative in its entirety or a
hybrid instrument in the form of a debt host contract and an “at-market” interest rate swap. Oftentimes
when these modifications occur, the new swap is structured so that its value is equivalent to the old
swap’s value immediately prior to the modification so that no cash exchanges hands. Generally, this is
accomplished by setting the fixed rate for the new swap at the rate that would result in it having the
same value pre and post modification. In these circumstances, the fair value of the modified (new)
swap as of the modification date would be considered its initial net investment, which would be
compared to the commensurate initial net investment to determine if the initial net investment
characteristic is met such that the new swap is determined to be a derivative in its entirety.

The following example illustrates the analysis to determine whether the criterion related to initial net
investment is met for a forward contract, and if not, whether the contract has an embedded derivative that
warrants separate accounting.

Example 2.2.2: Initial Net Investment—Forward Contract Embedded with Equity Derivative (from
ASC 815-10-55-74 to 55-76)
An entity enters into a forward contract that requires the purchase of 1 share of an unrelated entity's
common stock in 1 year for $110 (the market forward price) and at inception of the contract, the
entity elects to prepay the contract pursuant to its terms for $105 (the current price of the share of
common stock).
If no prepayment is made at inception, the contract would meet the criterion in paragraph 815-10-
15-83(b) because it does not require an initial net investment but, rather, contains an unexercised
election to prepay the contract at inception. If the contract gives the entity the option to prepay the
contract at a later date during its 1-year term (at $105 or some other specified amount), exercise of
that option would be accounted for as a loan that is repayable at $110 at the end of the forward
contract’s 1-year term. If, instead, the entity elects to prepay the contract at inception for $105, the
contract does not meet the definition of a freestanding derivative instrument. The initial net
investment of $105 is equal to the initial price of the 1 share of stock being purchased under the
contract and therefore is equal to the investment that would be required for other types of contracts
that would be expected to have a similar response to changes in market factors. That is, the initial
net investment is equal to the amount that would be exchanged to acquire the asset related to the
underlying.
However, the entity must assess whether that nonderivative instrument contains an embedded
derivative that, pursuant to paragraph 815-15-25-1, requires separate accounting as a derivative
unless the fair value election is made pursuant to paragraph 815-15-25-4. In this instance, the
prepaid contract is a hybrid instrument that is composed of a debt instrument as the host contract
(that is, a loan that is repayable at $110 at the end of the forward contract’s 1-year term) and an
embedded derivative based on equity prices. The host contract is a debt instrument because the

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holder has none of the rights of a shareholder, such as the ability to vote the shares and receive
distributions to shareholders. (See paragraph 815-15-25-16.) Unless the hybrid instrument is
remeasured at fair value with changes in value recorded in earnings as they occur, the embedded
derivative must be separated from the host contract because the economic characteristics and risks
of a derivative based on equity prices are not clearly and closely related to a debt host contract, and
a separate instrument with the same terms as the embedded derivative would be a derivative
instrument subject to the requirements of this Subtopic.

Note: Refer to Chapter 3 for further information on embedded derivatives.

A financial instrument or other contract that does not met the initial net investment characteristic of a
derivative is not a derivative.
2.2.1.4 Net settlement
Whether a financial instrument or other contract meets the definition of a derivative is often determined by
whether the net settlement characteristic exists. To meet the net settlement characteristic of a derivative,
a contract must either contractually permit or require net settlement or be able to be settled in a manner
that provides a result that is tantamount to contractual net settlement.
ASC 815-10-15-99 lists the following ways in which the net settlement characteristic is met:
• Contractual net settlement
• Net settlement through a market mechanism
• Net settlement by the delivery of a derivative instrument or an asset that is readily convertible to cash
A financial instrument or other contract that does not have any of the three forms of net settlement
previously described does not meet the definition of a derivative. Each of the three forms of net
settlement are discussed further in the following subsections.
2.2.1.4.1 Contractual net settlement
The following explanation of contractual net settlement is provided in ASC 815-10-15-100.
In this form of net settlement, neither party is required to deliver an asset that is associated with the
underlying and that has a principal amount, stated amount, face value, number of shares, or other
denomination that is equal to the notional amount (or the notional amount plus a premium or minus a
discount). (For example, most interest rate swaps do not require that either party deliver interest
bearing assets with a principal amount equal to the notional amount of the contract.) Net settlement
may be made in cash or by delivery of any other asset (such as the right to receive future payments—
see the discussion beginning in paragraph 815-10-15-104) whether or not that asset is readily
convertible to cash.
Whereas gross settlement refers to a two-way form of settlement where one party transfers cash and the
other party transfers a physical asset, contractual net settlement essentially refers to a one-way transfer
to settle a contract whereby only the party in a loss position transfers an asset (generally cash) to the
party in a gain position. For example, assume that Entity A holds an option contract to buy 10 shares of
Entity B’s common stock for $40 per share that permits net cash settlement. Entity A chooses to exercise
its option when Entity B’s common stock is trading at $50 per share. As permitted, Entity A chooses net
cash settlement and receives $100 ($50 fair value minus $40 strike price equals $10 gain per share. A
$10 gain per share multiplied by 10 shares equals $100). If instead the contract requires gross
settlement, Entity A would have paid the $400 extended strike price and received 10 shares of common
stock from Entity B in settlement of the contract. In other words, with gross settlement, entity B is required
to deliver an asset (the shares) that is associated with the underlying (price of the shares) in a number
equal to the notional amount of 10.

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Although contractual net settlement is often made in cash, the following additional forms of contractual
net settlement are listed and discussed further beginning in ASC 815-10-15-101:
• Net share settlement
• Net settlement in the event of nonperformance or default
• Structured settlement
• Net settlement of debt via the exercise of an embedded put or call option
Net share settlement
Net share settlement is considered to meet the net settlement characteristic of a derivative because even
though one party is required to deliver shares (an asset that is associated with an underlying), the number
of shares that are delivered do not equate to the notional amount of the contract plus or minus a premium
or discount. Effectively, the number of shares the holder receives upon exercise of the contract is reduced
in lieu of paying the exercise price in cash and receiving the full number of shares that are subject to the
contract as is the case with gross settlement. This is why net share settlement is commonly referred to as
cashless exercise. We most commonly see cashless exercise provisions in warrants or other option
agreements that give the holder the right to purchase shares. Whereas net cash settlement requires the
party in a loss position to transfer the gain (loss) in the form of cash to the party in the gain position, net
share settlement requires the party in a loss position to transfer the gain (loss) in the form of shares to the
party in the gain position. In the example of net cash settlement in the preceding section, Entity A (the
option holder) received $100 (i.e., the total gain in cash). If net share settlement was required in that
example, Entity A would have received 2 shares ($100 gain divided by $50 per share price) of Entity B’s
common stock as settlement. Like net cash settlement, net share settlement may be either permitted or
required.
A contract that can be net share settled may still qualify for the scope exception in ASC 815-10-15-74(a)
from the perspective of the issuer of the shares, in which case it would not be accounted for as a
derivative.
A financial instrument that requires or permits net share settlement has the net settlement characteristic
of a derivative.
Net settlement in the event of nonperformance or default
Contracts often contain penalties for nonperformance or default. When assessing whether a contract
meets the definition of a derivative, an entity should consider any nonperformance or default provision in
the contract before concluding net settlement does not exist because such provisions may constitute a
form of net settlement.
Variable, fixed, and mixed penalties
Generally, the net settlement characteristic of a derivative exists if the amount of the nonperformance or
default penalty is based substantively on the changes in price of the item that is the subject of the
contract. The concepts in the following table are provided in ASC 815-10-15-103 to illustrate this point.

Nonperformance or default penalty Net settlement characteristic

A variable penalty based on changes in the price The net settlement characteristic exists because
of the item(s) that is subject to the contract the amount of the penalty is based on changes in
(common in commodity contracts that require the price of the item(s) subject to the contract.
physical delivery) See ASC 815-10-15-103(a).

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Nonperformance or default penalty Net settlement characteristic

A fixed-penalty amount (e.g., $10,000) The net settlement characteristic does not exist
because the amount of the penalty is not based
on changes in the price of the item(s) subject to
the contract. See ASC 815-10-15-103(b).

A fixed-penalty amount per unit ($100 per unit) The net settlement characteristic does not exist
because the amount of the penalty is not based
on changes in the price of the item(s) subject to
the contract. See ASC 815-10-15-103(b).

A variable penalty based on changes in the price The net settlement characteristic does not exist
of the item that also includes an incremental because as noted in ASC 815-10-15-103(c), the
penalty of a fixed amount (or fixed amount per inclusion of a fixed penalty that is significant
unit) that is expected to be significant throughout enough to make the possibility of
the remaining life of the contract to make the nonperformance remote effectively requires
possibility of nonperformance remote. performance because it compels the delivery of
the asset that is associated with the underlying.
An entity should assess the significance of the
fixed incremental penalty only at the inception of
the contract and on its own as a disincentive for
nonperformance rather than its magnitude being
assessed in relation to the overall penalty.

Symmetrical provisions
ASC 815-10-55-18 describes a symmetrical provision as one that permits one party to net settle the
contract (by default or otherwise) under any pricing circumstance and participate in either favorable price
changes only or both favorable and unfavorable changes in the underlying. A symmetrical provision
constitutes contractual net settlement because it does not require the delivery of an asset that is
associated with the underlying and has a quantity equal to the notional amount.
Asymmetrical default provisions
ASC 815-10-15-103(d) indicates that an asymmetrical default provision does not meet the net settlement
characteristic of a derivative. ASC 815-10-20 defines an asymmetrical default provision as a
nonperformance penalty provision that requires the defaulting party to compensate the nondefaulting
party for any loss incurred but does not allow the defaulting party to receive the effect of favorable price
changes. However, ASC 815-10-55-17 states that:
…a pattern of having the asymmetrical default provision applied in contracts between certain
counterparties would indicate the existence of a tacit agreement between those parties that the party in
a loss position would always elect the default provision, thereby resulting in the understanding that
there would always be net settlement. Under those circumstances, those kinds of contracts would meet
the characteristic described as net settlement in ASC 815-10-15-100.
As this guidance implies, if an asymmetrical default provision exists, an entity should consider how the
parties have historically settled similar contracts between them. A pattern of electing to exercise the
default provision and net settling contracts indicates that the two parties have tacitly agreed to settle the
contracts net such that the net settlement characteristic of a derivative would be deemed to exist.
The following examples explain asymmetrical default provisions that do not constitute net settlement.

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Example 2.2.3: Asymmetrical Default Provision Does Not Constitute Net Settlement (from ASC
815-10-55-10 to 55-16)
Many commodity forward contracts contain default provisions that require the defaulting party (the
party that fails to make or take physical delivery of the commodity) to reimburse the nondefaulting
party for any loss incurred as illustrated in the following examples:
a. If the buyer under the forward contract (Buyer) defaults (that is, does not take physical delivery
of the commodity), the seller under that contract (Seller) will have to find another buyer in the
market to take delivery. If the price received by Seller in the market is less than the contract
price, Seller incurs a loss equal to the quantity of the commodity that would have been
delivered under the forward contract multiplied by the difference between the contract price and
the current market price. Buyer must pay Seller a penalty for nonperformance equal to that
loss.
b. If Seller defaults (that is, does not deliver the commodity physically), Buyer will have to find
another seller in the market. If the price paid by Buyer in the market is more than the contract
price, Seller must pay Buyer a penalty for nonperformance equal to the quantity of the
commodity that would have been delivered under the forward contract multiplied by the
difference between the contract price and the current market price.
For example, Buyer agreed to purchase 100 units of a commodity from Seller at $1.00 per unit:
a. Assume Buyer defaults on the forward contract by not taking delivery and Seller must sell the
100 units in the market at the prevailing market price of $.75 per unit. To compensate Seller for
the loss incurred due to Buyer’s default, Buyer must pay Seller a penalty of $25.00—that is,
100 units × ($1.00 – $.75).
b. Similarly, assume that Seller defaults and Buyer must buy the 100 units it needs in the market
at the prevailing market price of $1.30 per unit. To compensate Buyer for the loss incurred due
to Seller’s default, Seller must pay Buyer a penalty of $30.00—that is, 100 units × ($1.30 –
$1.00).
Note that an asymmetrical default provision is designed to compensate the nondefaulting party for a
loss incurred. The defaulting party cannot demand payment from the nondefaulting party to realize
the changes in market price that would be favorable to the defaulting party if the contract were
honored.
Under the forward contract in the example, if Buyer defaults when the market price is $1.10, Seller
will be able to sell the units of the commodity into the market at $1.10 and realize a $10.00 greater
gain than it would have under the contract. In that circumstance, the defaulting Buyer is not required
to pay a penalty for nonperformance to Seller, nor is Seller required to pass the $10.00 extra gain to
the defaulting Buyer.
Similarly, if Seller defaults when the market price is $.80, Buyer will be able to buy the units of the
commodity in the market and pay $20.00 less than under the contract. In that circumstance, the
defaulting Seller is not required to pay a penalty for nonperformance to Buyer, nor is Buyer required
to pass the $20.00 savings on to the defaulting Seller.
In a forward contract with only an asymmetrical default provision, neither Buyer nor Seller can
realize the benefits of changes in the price of the commodity through default on the contract. That is,
Buyer cannot realize favorable changes in the intrinsic value of the forward contract except in both
of the following circumstances:
a. By taking delivery of the physical commodity
b. In the event of default by Seller (which is an event beyond the control of Buyer).
Similarly, Seller cannot realize favorable changes in the intrinsic value of the forward contract except
in either of the following circumstances:

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a. By making delivery of the physical commodity

b. In the event of default by Buyer, which is an event beyond the control of Seller.

Structured settlement
As an alternative to immediate net cash settlement of a contract, ASC 815-10-15-104 and ASC 815-10-
55-19 address situations whereby the party in a gain position is paid over time rather than in one payment
at settlement. Such a structured payout meets the net settlement characteristic of a derivative if the fair
value of the cash flows that will be received (paid) approximates the amount that would be received (paid)
if the contract had provided for immediate and full payout at settlement.
However, ASC 815-10-15-105 and ASC 815-10-55-20 note that the net settlement characteristic of a
derivative does not exist if one party must make an investment in or borrow from the other party to obtain
the benefits of the gain on a contract over time as a traditional adjustment to either the yield on the
amount invested or the interest element on the amount borrowed. A very common example of this is a
fixed-rate mortgage commitment whereby a potential borrower obtains a commitment to obtain a
mortgage at a fixed rate. If rates go up, the borrower will be in a gain position. However, the borrower can
only realize the benefits of that gain in the form of a lower interest rate over the life of the mortgage if the
borrower actually borrows the funds from the party who issued the mortgage commitment.
Conversely, ASC 815-10-15-106 indicates that if that adjustment to either the yield on the amount
invested or the interest element on the amount borrowed previously discussed was nontraditional, the net
settlement characteristic of a derivative may be met. ASC 815-10-55-21 provides the following example:
…if a contract required the party in a gain position under the contract to invest $100 in the other party’s
debt instrument that paid an abnormally high interest rate of 5,000 percent per day for a term whose
length is dependent on the changes in the contract’s underlying, an analysis of those terms would lead
to the conclusion that the contract’s settlement terms were in substance a structured payout of the
contract’s gain and thus that contract would be considered to have met the characteristic of net
settlement in that paragraph.
Net settlement of debt via the exercise of an embedded put or call option
In accordance with ASC 815-10-15-107, the potential settlement of a debt instrument through the
exercise of a prepayment feature, or call or put option that is embedded within it meets the net settlement
characteristic of a derivative. This is because neither the debtor nor the creditor is required to deliver an
asset that is associated with the underlying. Refer to ASC 815-10-15-108 to 15-109 for further
information.
When contractual net settlement does not exist
If a financial instrument or other contract does not permit or require net settlement according to its terms,
that instrument or contract may still meet the net settlement characteristic of a derivative if it can be
settled net by either of the following:
• A market mechanism
• Delivery of a derivative instrument or an asset that is readily convertible to cash
2.2.1.4.2 Net settlement through a market mechanism
Unlike contractual net settlement where neither party is required to deliver an asset that is associated with
the underlying as described in ASC 815-10-15-100, when net settlement exists through a market
mechanism, one of the parties is required to deliver an asset that is associated with the underlying
however a market mechanism facilitates net settlement. An example of a market mechanism is an
exchange through which an entity can sell a contract or enter into an offsetting contract. Many derivative
instruments are traded in active markets where they can be settled net before they expire.

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Although an entity should interpret the term market mechanism broadly, a market mechanism must
possess all of the primary characteristics described in ASC 815-10-15-111. ASC 815-10-15-113 to 15-
116 provides indicators for each of those primary characteristics. Not all of the indicators need to be
present to satisfy a particular primary characteristic for an entity to conclude that a market mechanism
exists for a particular contract. The following table summarizes the primary characteristics of a market
mechanism, including the indicators for evaluating their existence.

Indicators that the primary

Primary characteristic Description characteristic is met

Ready liquidation A market mechanism provides a • There is access to potential

way to settle a contract that counterparties regardless of
enables one party to easily the seller’s size or market
liquidate its net position. It position.
enables an entity to realize the
• The risks taken on by a
gain or loss on a contract
market maker from
through a net payment in cash
acquiring a contract can be
or any other asset. If settlement
transferred in a manner
results only in a gross exchange
other than by changing the
of cash (or payment-in-kind) for
original form of the contract.
an asset, this primary
characteristic of a market
mechanism does not exist.

Full relief of rights and A market mechanism enables • There are multiple market
obligations one of the parties to a contract participants who are willing
to relinquish all of its future and able to assume the
rights or avoid all of its future rights and obligations of the
obligations under the contract. If seller under a contract.
a contract does not allow an
• The market has sufficient
original party to the contract to
liquidity for the contract,
assign its rights and obligations
which is indicated by
under the contract to another
transaction volume and a
party, the contract does not
relatively narrow observable
meet the characteristic of net
bid-ask spread.
settlement through a market
mechanism. Offsetting (or the
ability to offset) one contract
with another, in and of itself,
does not meet the characteristic
of a market mechanism because
no party is relieved of both their
rights and obligations under the
original contract. Conversely, an
exchange that offers a ready
opportunity to offset a contract
that cancels the rights and
obligations of that contract
because the exchange is the
counterparty does constitute a
market mechanism. Refer to

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Indicators that the primary

Primary characteristic Description characteristic is met
implementation guidance in
ASC 815-10-55-92 to 55-98.

Lack of significant transaction A market mechanism enables a The transaction costs are less
costs party to the contract to liquidate than 10% of the fair value of the
its net position without incurring contract. An exchange, as an
significant transaction costs. example, may allow the
This characteristic of a market opportunity for a party to sell a
mechanism focuses on a single contract and be relieved of its
contract. As a result, the contractual rights and
absence of a liquid market for a obligations without incurring
group of contracts is not a factor significant transaction costs.
in determining whether a market
mechanism exists.
Whether the market could
rapidly absorb the amount of
assets to be delivered under the
contract without significantly
affecting the price of the asset is
not a consideration for this
primary characteristic of a
market mechanism.

Expeditious liquidation A market mechanism enables a • Binding prices for the

party to the contract to liquidate contract are readily
its net position without available.
significant negotiation and due
• The transfer of the
diligence. In addition, liquidation
instrument involves
occurs within a period of time
standardized documentation
that is customary for settling the
and standardized settlement
type of contract.
procedures.
• Sales of individual contracts
do not require significant
negotiation.
• Sales of individual contracts
do not require unique
structuring.
• The extent of legal
consultation and document
review is such that the
closing period is not
extensive.

The possible existence of a market mechanism is performed at contract inception and on an ongoing
basis during the life of the contract. In other words, different conclusions may be reached at different

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times as to whether or not net settlement through a market mechanism exists for a contract. See example
2.2.5 in Section 2.2.1.4.3 of this chapter about net settlement at inception and throughout the life of a
contract.
A futures exchange generally satisfies all of the characteristics of a market mechanism as elaborated on
in the following table.

Primary
characteristic Does the primary characteristic exist for a futures exchange?

Ready liquidation Yes. The futures exchange creates a market for the counterparties to the futures
contract.

Full relief of rights Yes. At any point in time during the term of a futures contract, a party can close
and obligations out its position by transferring it to another party. As a result, the party closing out
its position is relieved of all of its rights and obligations under the contract and
pays or receives the fair value change in the contract since its inception.

Lack of Yes. A futures exchange enables a party to a futures contract to liquidate its net
significant position without incurring significant transaction costs.
transaction costs

Expeditious Yes. A futures exchange enables a party to the contract to liquidate its net
liquidation position with no negotiation or due diligence.

A market without an exchange, but with many brokers

Question: Does a market that lacks an exchange for settling certain contracts, but which possesses
many brokers for effectuating such transactions qualify as a market mechanism under ASC 815?
Answer: It depends on the facts and circumstances. The existence of many brokers to settle certain
contracts would not constitute a market mechanism in any of the following situations.
• Binding prices are not always available for the contract (the expeditious liquidation characteristic
does not exist)
• The broker is only making payment or accepting payment on behalf of the party to the contract
without fully relieving the rights and obligations of the party under the contract (the full relief of
rights and obligations characteristic does not exist)
• Transaction costs are 10% or more of the fair value of the contract (the lack of significant
transaction costs characteristic does not exist)

Effects of an assignment clause on a market mechanism

A contract may contain a clause that permits one or both parties to assign its rights and obligations to
another party with the permission of the other party to the contract. This type of assignment would replace
the nonperformance risk of the assigning party with the nonperformance risk of a new party if the
assigning party were released of all of its contractual rights and obligations. Often the nonassigning party
could withhold consent in certain circumstances (e.g., one party wishes to assign the contract to another
party who is a higher credit risk than the assignor). An entity would have to analyze an assignment clause
to determine if a party is permitted from being relieved of all its rights and obligations under the contract

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(a necessary step in determining whether a market mechanism exists). ASC 815-10-15-117 provides the
following relevant guidance:
As noted in the primary characteristic in paragraph 815-10-15-111(b), an assessment of the substance
of any assignment clause is required to determine whether that assignment clause precludes a party
from being relieved of all rights and obligations under the contract. Although permission to assign a
contract shall not be unreasonably withheld by the counterparty in accordance with the terms of a
contract, an assignment feature cannot be viewed simply as a formality because it may be invoked at
any time to prevent the nonassigning party from being exposed to unacceptable credit or performance
risk. Accordingly, the existence of an assignment clause may or may not permit a party from being
relieved of its rights and obligations under the contract. If it is remote that the counterparty will withhold
permission to assign the contract, the mere existence of the clause shall not preclude the contract from
possessing the net settlement characteristic described in paragraph 815-10-15-110 as a market
mechanism. Such a determination requires assessing whether a sufficient number of acceptable
potential assignees exist in the marketplace such that assignment of the contract would not result in
imposing unacceptable credit risk or performance risk on the nonassigning party. Consideration shall
be given to past counterparty and industry practices regarding whether permission to be relieved of all
rights and obligations under similar contracts has previously been withheld. However, if it is reasonably
possible or probable that the counterparty will withhold permission to assign the contract, the contract
does not possess the net settlement characteristic described in paragraph 815-10-15-110 as a market
mechanism.
2.2.1.4.3 Net settlement by the delivery of a derivative instrument or an asset that is readily
convertible to cash
If a financial instrument or other contract does not provide for contractual net settlement and cannot be
settled through a market mechanism, that instrument or contract may still meet the net settlement
characteristic of a derivative if its settlement will result in the delivery of a derivative instrument or an
asset that is readily convertible to cash.
Unlike contractual net settlement, in this form of net settlement, as indicated in ASC 815-10-15-119, one
of the parties to a contract is required to deliver an asset that is associated with the underlying (e.g., the
delivery of gold under a contract where the price of gold is the underlying), but that asset is either:
• Readily convertible to cash, or
• Is itself a derivative instrument (e.g., net settlement would exist in a swaption contract because the
asset to be delivered, a swap, is a derivative)
The thought process is that if the asset to be delivered can be readily converted to cash, the party taking
delivery is in a position that does not differ substantially from net settlement. In other words, the party
would be indifferent about whether it receives that asset or net settles the contract as discussed in
ASC 815-10-15-122. This would be the case if there is an active market whereby the asset could be sold
for a net amount of cash that is equal to or not significantly less than the amount that would be received
under a net settlement provision. ASC 815-10-15-126 notes that costs to convert an asset to cash are
significant if they are 10% or more of the gross sales proceeds that would be received in the closest or
most economical active market.
When determining if the asset to be delivered can be readily converted to cash, as mentioned in
ASC 815-10-15-123, an entity should not combine individual instruments. ASC 815-10-55-111 illustrates
this in the context of a long-term commodity supply contract whereby determining whether the asset to be
delivered can be readily converted to cash is based on the quantity to be delivered on each individual
delivery date rather than the total quantity that will be delivered over the entire contract term.
The following are examples of assets that depending on the facts and circumstances, may be considered
readily convertible to cash:

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• An exchange-traded security whereby the number of shares to be delivered under the contract is
small relative to the daily trading volume of that security
• Commodities traded in an active market (e.g., gold, crude oil, gas)
• A unit of foreign currency that is readily convertible into the reporting entity’s functional currency if
there are no regulatory restrictions governing the trade of the currency as described in ASC 815-10-
15-121
ASC 815-10-15-129 points out that the ability to use an asset as collateral in a borrowing does not in and
of itself mean that the asset is readily convertible to cash.
Readily convertible to cash analysis
The definition of readily convertible to cash that is provided in the master glossary is as follows.
Assets that are readily convertible to cash have both of the following:
a. Interchangeable (fungible) units
b. Quoted prices available in an active market that can rapidly absorb the quantity held by the entity
without significantly affecting the price.
The following four conditions must exist for an asset to be deemed to be readily convertible to cash.
• The assets that are required to be delivered are interchangeable, fungible units
• The assets that are required to be delivered have prices quoted in an active market
• The quantity of assets to be delivered can be rapidly absorbed in an active market without
significantly affecting the price
• The conversion costs must not be significant
The conditions that must exist for an asset to be considered to be readily convertible to cash such that the
net settlement characteristic of a derivative exists are discussed further beginning in the following
paragraph.
Assets that are interchangeable (fungible) units
For assets to be delivered pursuant to a contract to be considered readily convertible to cash such that
the net settlement characteristic of a derivative is met, the assets must be interchangeable. The individual
assets that comprise a group of assets are interchangeable if each of the individual assets within the
group are indistinguishable from one another. This means that any one of the individual assets within the
group could replace any one of the other individual assets within that group without the replacement
making a difference or being noticed. Commodity products of the same likeness (e.g., bushels of wheat)
as well as many manufactured products of the same likeness (e.g., rubber tires of the same exact type)
are considered indistinguishable from one another.
Quoted prices in an active market
For assets to be delivered under a contract to be considered readily convertible to cash such that the net
settlement characteristic of a derivative is met, the assets must have prices quoted in an active market.
The master glossary provides the following definition of an active market.
A market in which transactions for the asset or liability take place with sufficient frequency and volume
to provide pricing information on an ongoing basis.

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The market must be able to rapidly absorb the quantity of assets to be delivered without
significantly affecting the quoted price
For the assets to be delivered under a contract to be considered readily convertible to cash such that the
net settlement characteristic of a derivative is met, the market must be active enough to be able to rapidly
absorb the quantity of assets to be delivered without significantly affecting the quoted price. To determine
this, an entity should consider the quantity of the asset that will be delivered under the contract relative to
the daily transaction volume of that asset. In addition, an entity should consider the effect on the market
price of the asset if that quantity of the asset was sold within a few days as well as the feasibility of doing
so. Generally, a publicly traded security can be rapidly absorbed in an active market without a significant
effect on the quoted price of the security if the number of shares of the security is small relative to the
shares daily trading volume. Although GAAP does not provide a definition of “within a few days,” we have
observed in practice that this is typically viewed to mean less than one week. Therefore, if the quantity of
assets to be delivered could be sold over a period of time that is less than one week without significantly
affecting the market price of those assets, we believe that the assets would be considered readily
convertible to cash assuming the other conditions are met.
A contract may involve the delivery of assets on multiple dates. ASC 815-10-15-128 requires an entity to
determine whether the expected quantity of each delivery can be rapidly absorbed in the market without
significantly affecting the quoted price. For example, if an entity contracts to deliver 1,000 units of a
particular commodity on the first day of the month over an 18-month period, the entity does not consider
whether the market can rapidly absorb 18,000 units on a single date. Rather, it determines whether the
market can rapidly absorb 1,000 units of the commodity on the first day of each month over the 18-month
period without significantly affecting the price of the commodity on those dates. A contract may not
specify multiple delivery dates, but may allow for settlement in increments. For example, a contract may
permit the entity to purchase 18,000 units in minimum increments of 1,000 units over the course of the
next 18 months, in which case the minimum increment of 1,000 units would be compared to the daily
transaction volume of the asset in determining if it could be rapidly absorbed in the market. See Example
2.2.6—Net Settlement—Effect of Multiple Deliveries.
ASC 815 provides the following example illustrating how to consider daily transaction volumes when
determining if net settlement exists. This example discusses net settlement in the context of embedded
features rather than a freestanding instrument. More specifically, the example discusses a single bond
with multiple embedded conversion options and multiple bonds each having a single embedded
conversion option. Although the example involves embedded features, the concepts regarding net
settlement are the same for an embedded feature and a freestanding instrument. Refer to Chapter 3 for
further information on embedded derivatives.

Example 2.2.4: Net Settlement—Readily Convertible to Cash - Effect of Daily Transaction

Volumes (from ASC 815-10-55-99 to 55-110)
The following Cases illustrate consideration of the relevance of daily transaction volumes to the
characteristic of net settlement in deciding whether, from the investor’s perspective, the convertible
bond contains an embedded derivative that must be accounted for separately:
a. Single bond with multiple conversion options (Case A).
b. Multiple bonds each having single conversion option (Case B).
The Cases illustrate that the form of the financial instrument is important; paragraph 815-10-15-123
explains that individual instruments cannot be combined for evaluation purposes to circumvent
compliance with the criteria beginning in paragraph 815-10-15-119. Further, paragraph 815-10-15-
111(c) explains that contracts shall be evaluated on an individual basis, not on an aggregate-
holdings basis.

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Case A: Single Bond with Multiple Conversion Options

Investor A holds a convertible bond classified as an available-for-sale security under Topic 320. The
bond has all of the following additional characteristics:
a. It is not exchange-traded and can be converted into common stock of the debtor, which is
traded on an exchange.
b. It has a face amount of $100 million and is convertible into 10 million shares of common stock.
c. It may be converted in full or in increments of $1,000 immediately or at any time during the next
2 years.
d. If it were converted in a $1,000 increment, Investor A would receive 100 shares of common
stock.
Assume further that the market condition for the debtor’s stock is such that up to 500,000 shares of
its stock can be sold rapidly without the share price being significantly affected.
The embedded conversion option meets the criteria in paragraph 815-10-15-83(a) through (b) but
does not meet the criteria in paragraphs 815-10-15-100 and 815-10-15-110, in part because the
option is not traded and it cannot be separated and transferred to another party.
It is clear that the embedded equity conversion feature is not clearly and closely related to the debt
host instrument. [RSM Commentary: As discussed in Chapter 3, this factor is relevant in determining
if an embedded derivative requires separate recognition from the host contract.]
The bond may be converted in $1,000 increments and those increments, by themselves, may be
sold rapidly without significantly affecting price, in which case the criteria discussed beginning in
paragraph 815-10-15-119 would be met. However, if the holder simultaneously converted the entire
bond, or a significant portion of the bond, the shares received could not be readily converted to cash
without incurring a significant block discount.
From Investor A's perspective, the conversion option should be accounted for as a compound
embedded derivative in its entirety, separately from the debt host, because the conversion feature
allows the holder to convert the convertible bond in 100,000 increments and the shares converted in
each increment are readily convertible to cash under the criteria discussed beginning in paragraph
815-10-15-119. Investor A need not determine whether the entire bond, if converted, could be sold
without affecting the price. [RSM Commentary: The conversion option would also be a compound
embedded derivative from the bond issuer’s perspective; however, ASC 815-10-15-74(a) provides
an exception to derivative treatment such that the issuer would not account for it as a derivative if all
the requirements to apply that exception are met.]
Because the $100 million bond is convertible in increments of $1,000, the convertible bond is
essentially embedded with 100,000 equity conversion options, each with a notional amount of 100
shares. Each of the equity conversion options individually has the characteristic of net settlement
discussed beginning in paragraph 815-10-15-119 because the 100 shares to be delivered are
readily convertible to cash. Because the equity conversion options are not clearly and closely
related to the host debt instrument, they must be separately accounted for. However, because an
entity cannot identify more than 1 embedded derivative that warrants separate accounting, the
100,000 equity conversion options must be bifurcated as a single compound derivative. (Paragraphs
815-15-25-7 through 25-10 say an entity is not permitted to account separately for more than one
derivative feature embedded in a single hybrid instrument.)
There is a substantive difference between a $100 million convertible debt instrument that can be
converted into equity shares only at one time in its entirety and a similar instrument that can be
converted in increments of $1,000 of tendered debt; the analysis of the latter should not presume
equality with the former.
Case B: Multiple Bonds Each Having Single Conversion Option

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Investor B has 100,000 individual $1,000 bonds that each convert into 100 shares of common stock.
Assume those bonds are individual instruments but they were issued concurrently to Investor B.
From Investor B's perspective, the individual bonds each contain an embedded derivative that must
be separately accounted for. Each individual bond is convertible into 100 shares, and the market
would absorb 100 shares without significantly affecting the price of the stock.

Significance of conversion costs

For the assets to be delivered under a contract to be considered readily convertible to cash such that the
net settlement characteristic of a derivative is met, the transaction costs of conversion must not be
significant. This is because significant transaction costs would affect whether an entity would be
indifferent to settling the contract on a net cash basis or by receiving the assets associated with the
underlying of the contract and converting those assets to cash. The costs to be considered are not only
transaction fees and sales commissions, but any cost to obtain the asset and convert it to cash, which
could include, but not be limited to transportation, maintenance, and storage.
ASC 815-10-15-125 to 15-127 provides the following guidance for purposes of assessing the significance
of conversion costs.
If an entity determines that the estimated costs that would be incurred to immediately convert the asset
to cash are not significant, then receipt of that asset puts the entity in a position not substantially
different from net settlement. Therefore, an entity shall evaluate, in part, the significance of the
estimated costs of converting the asset to cash in determining whether those assets are readily
convertible to cash.
For purposes of assessing significance of such costs, an entity shall consider those estimated
conversion costs to be significant only if they are 10 percent or more of the gross sales proceeds
(based on the spot price at the inception of the contract) that would be received from the sale of those
assets in the closest or most economical active market.
The assessment of the significance of those conversion costs shall be performed only at inception of
the contract.
Determining whether shares of stock are readily convertible to cash
A financial instrument or other contract may require settlement by delivery of shares of stock. As indicated
in ASC 815-10-15-130, if a contract will be settled by delivering a security that is publicly traded in a
market that is not very active, determining whether the security is readily convertible to cash hinges on
the amount of shares or other units of the security to be delivered relative to the daily trading volume of
that security. If the number of shares of the security to be delivered is relatively small compared to the
daily trading volume, the security is readily convertible to cash assuming the other conditions are met.
However, that same security would not be readily convertible to cash if the number of shares to be
exchanged is large relative to the daily trading volume. See Example 7 that begins in ASC 815-10-55-99.
The need to consider the smallest increment is applicable here as well as in the aforementioned example.
Stock purchase warrants
Stock purchase warrants generally give the holder the ability to purchase a stated number of an entity’s
shares for a stated price during a stated term. These warrants may meet the definition of a derivative,
either because they have a cashless exercise provision (i.e., net share settlement exists as illustrated
under ASC 815-10-55-90) or because the shares to be delivered if the warrant is exercised are readily
convertible to cash.
Stock purchase warrants often place restrictions on the sale or transfer of the shares of stock that are
received from the exercise of the warrant. These restrictions may affect whether the shares to be
delivered under the warrant are considered readily convertible to cash. In accordance with ASC 815-10-
15-131 to 15-138, if the issuer restricts the sale or transfer of the underlying stock for greater than

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31 days from the date the warrant is exercised, the stock would not be considered readily convertible to
cash unless the holder has the ability by contract or otherwise to cause a requirement to sell to be met
within 31 days of exercise. Conversely, an issuer’s restriction only on the ability to post the shares as
collateral would not by itself prevent the stock from being considered readily convertible to cash. If the
shares of actively traded stock to be received upon the exercise on the stock purchase warrant can be
reasonably expected to qualify for sale within 31 days of exercise, which may be the case for example
under SEC Rule 144, such shares would be considered readily convertible to cash absent any greater
issuer-imposed restriction. It is important to note that even if there are no restrictions on the sale of the
shares, the entity would still consider whether the shares can be readily converted to cash as discussed
further in ASC 815-10-15-136. Additionally, as noted in ASC 815-10-15-132, the accounting for restricted
stock to be received upon exercise of a warrant should not be applied to other types of contracts by
analogy.
Ongoing assessment of a market mechanism and whether the assets to be delivered are readily
convertible to cash
ASC 815-10-15-118 requires an entity to perform the assessment of whether a market mechanism exists
at the inception of a contract and on an ongoing basis throughout the life of a contract. Similarly,
ASC 815-10-15-139 requires an entity to assess whether the assets to be delivered under a financial
instrument or a contract are readily convertible to cash at the inception of a contract and on an ongoing
basis. Conclusions reached may change as market activity changes. The following example illustrates
these requirements.

Example 2.2.5: Net Settlement at Inception and Throughout a Contract's Life (from ASC 815-10-
55-84 to 55-89)
As required by paragraphs 815-10-15-110 through 15-118 and 815-10-15-119 through 15-120,
respectively, the evaluation of whether a market mechanism exists and whether items to be
delivered under a contract are readily convertible to cash must be performed at inception and on an
ongoing basis throughout a contract’s life. For example, if a market develops, if an entity effects an
initial public offering, or if daily trading volume changes for a sustained period of time, then those
events need to be considered in reevaluating whether the contract meets the definition of a
derivative instrument. Similarly, if events occur after the inception or acquisition of a contract that
would cause a contract that previously met the definition of a derivative instrument to cease meeting
the criteria (for example, an entity becomes delisted from a national stock exchange), then that
contract cannot continue to be accounted for under this Subtopic. The guidance in paragraphs 815-
10-15-125 through 15-127 about assessing the significance of transaction costs is not relevant when
determining whether such a contract no longer meets the definition of a derivative instrument.
The following Cases illustrate the importance of ongoing evaluation:
a. Market mechanism develops after contract inception (Case A).
b. Initial public offering makes shares readily convertible to cash after contract inception (Case B).
c. Increased trading activity makes shares readily convertible to cash after contract inception
(Case C).
d. Delisting makes shares not readily convertible to cash after contract inception (Case D).
Case A: Market Mechanism Develops After Contract Inception
A purchase contract for future delivery of commodity X is entered into and, at the inception of the
contract, the market for contracts on commodity X is a relatively thin market, such that brokers do
not stand ready to buy and sell the contracts. As time passes, the market for commodity X matures
and broker-dealer networks develop. The existence of the broker-dealer market and the ability of the
purchaser to be relieved of its rights and obligations under the purchase contract are consistent with
the characteristics of a market mechanism as discussed beginning in paragraph 815-10-15-110.

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Accordingly, the purchase contract will have the characteristics of net settlement as defined by
paragraph 815-10-15-110 as broker-dealer networks develop.
Case B: Initial Public Offering Makes Shares Readily Convertible to Cash After Contract
Inception
A nontransferable forward contract on a nonpublic entity's stock that provides only for gross physical
settlement is generally not a derivative instrument because the net settlement criteria are not met. If
the entity, at some point in the future, accomplishes an initial public offering of its shares and the
original contract is still outstanding, the shares to be delivered would be considered to be readily
convertible to cash (assuming that the shares under the contract could be rapidly absorbed in the
market without significantly affecting the price).
Case C: Increased Trading Activity Makes Shares Readily Convertible to Cash After Contract
Inception
A nontransferable forward contract on a public entity's stock provides for delivery on a single date of
a significant number of shares that, at the inception of the contract, would significantly affect the
price of the public entity's stock in the market if sold within a few days. As a result, the contract does
not satisfy the readily-convertible-to-cash criterion. However, at some later date, the trading activity
of the public entity's stock increases significantly. Upon a subsequent evaluation of whether the
shares are readily convertible to cash, the number of shares to be delivered would be minimal in
relation to the new average daily trading volume such that the contract would then satisfy the net
settlement characteristic.
Case D: Delisting Makes Shares Not Readily Convertible to Cash After Contract Inception
A nontransferable forward contract on a public entity's stock meets the net settlement criteria (as
discussed beginning in paragraph 815-10-15-119) in that, at inception of the contract, the shares are
expected to be readily convertible to cash when delivered under the contract. Assume that there is
no other way that the contract meets the net settlement criteria. The public entity subsequently
becomes delisted from the stock exchange, thus causing the shares to be delivered under the
contract to no longer be readily convertible to cash.

The following example illustrates the effect of multiple deliveries on the analysis of the net settlement
characteristic of a derivative.

Example 2.2.6: Net Settlement—Effect of Multiple Deliveries (from ASC 815-10-55-111 to 55-118)
This Example illustrates the effect of multiple deliveries on the consideration of net settlement
described in Section 815-10-15. An entity has a five-year supply contract that obligates it to deliver
at a specified price each month a specified quantity of a commodity that has interchangeable
(fungible) units and for which quoted prices are available in an active market. However, the quoted
prices that are available are for either a spot sale or a forward sale of the commodity with a maturity
of 12 months or less. In other words, the forward market for the commodity beyond the next 12
months does not currently exist and is not expected to develop. There are brokers who are willing to
take over the rights and obligations relating to the next 12 months of the supply contract, but not for
periods beyond the next 12 months. With respect to the active spot market for the commodity, it can
rapidly absorb the quantity specified in the supply contract for each individual month but not the total
quantity for the entire five-year period in a single transaction (or in multiple transactions over the
course of a day or so).
The supply contract does not contain a net settlement provision as described in paragraphs 815-10-
15-100 through 15-109.
The five year commodity supply contract does not meet the net settlement characteristic in
paragraph 815-10-15-110 at its inception because there is no market mechanism to net settle the
entire five-year contract—the forward market exists only for the next 12 months while the contract
period is for the next five years. Accordingly, there is no market mechanism for the entity to settle

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the entire contract on a net basis. However, if the contract contained contractually separable
increments that individually met the net settlement criteria, those contractually separable increments
may be embedded derivatives. In this instance, the brokers in the market will not assume the rights
and obligations of the entire contract. Note that the market mechanism in the net settlement
characteristic in paragraph 815-10-15-110 relates to whether a party to the contract can be relieved
of its rights and obligations under the entire contract, not merely whether an independent broker in
the market stands ready to assume the selected rights and obligations.
The definition of a derivative instrument in this Subtopic must be applied based on the actual terms
of the contract, including its maturity date and the total quantity of the underlying. This Subtopic
does not permit bifurcation of a five-year contract into five annual contracts, 60 monthly contracts, or
1,826 daily contracts in an attempt to assert that only a portion of the contract meets the definition of
a derivative instrument. To do so would be to disregard one of the critical terms of the contract, that
is, the term to the maturity date of the contract.
Based on the guidance in paragraph 815-10-15-3, the five-year commodity supply contract in the
example, would, at the beginning of the fifth year, be reevaluated to determine whether the contract
meets the net settlement characteristic in paragraph 815-10-15-110 and would likely meet the
characteristic because a forward market for the contract would then exist for the remaining term of
the contract.
The five-year commodity supply contract meets the net settlement characteristic as discussed
beginning in paragraph 815-10-15-119. The criterion discussed beginning in that paragraph is met
because an active spot market for the commodity exists today and is expected to be in existence in
the future for each delivery date (for example, for quantities to be delivered each day or each month
for the next five years) under the multiple delivery supply contract. The spot market can rapidly
absorb the quantities specified for each monthly delivery without significantly affecting the price. The
fact that the spot market may not be able to absorb within a few days the quantity specified in the
entire five-year contract is irrelevant because the performance of the contract is spread out over a
five-year period and, therefore, is not expected to occur within a few days.
This Example does not address whether or not the contract would qualify for the normal purchases
and normal sales scope exception as discussed beginning in paragraph 815-10-15-22.

2.3 Scope exceptions

The scope of ASC 815 is comprised of a broadly crafted definition of a derivative along with an extensive
list of scope exceptions. The FASB intentionally created a broad definition of a derivative to ensure that
instruments that truly are derivatives were captured by the definition. However, given the breadth of the
definition, certain instruments that the FASB did not intend to be accounted for as derivatives may meet
the definition of a derivative. As a result, ASC 815 contains many scope exceptions, which are discussed
in this section.
The following table provides a high-level summary of each of the instruments and contracts listed in
ASC 815-10-15-13 that are exempt from the derivative accounting requirements of ASC 815. Each of the
scope exceptions and the requirements that need to be met for them to apply are described further in
subsequent sections of this chapter.

Scope Exception Can apply to: Description of contracts scoped out

Regular-way security Both parties to A contract that provides “for delivery of a security within
trades (ASC 815-10- the contract the period of time (after the trade date) generally
15-15 to 15-21) established by regulations or conventions in the
marketplace or exchange in which the transaction is
being executed.”

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Scope Exception Can apply to: Description of contracts scoped out

Normal purchases and Both buyer and A contract for the purchase or sale of a commodity or
normal sales (ASC seller (the buyer other non-financial instrument that will be delivered in
815-10-15-22 to 15-51) and seller may quantities expected to be used or sold by the reporting
come to different entity in the normal course of its business.
conclusions)

Certain insurance The holder and Certain insurance contracts that entitle the holder of the
contracts and upon the issuer of the contract to be compensated only as a result of an
adoption of ASU 2018- contract identifiable insurable event other than a change in price.
12, market risk benefits
(ASC 815-10-15-52 to
15-57)

Certain financial The guarantor A financial guarantee that meets very narrow criteria,
guarantee contracts and guaranteed including the fact that the guarantee provides for
(ASC 815-10-15-58) party payments to be made to the guaranteed party solely to
reimburse that party for an obligor’s failure to make a
payment to the guaranteed party.

Certain nonexchange Both parties to A contract that is not traded on an exchange and that
traded contracts (ASC the contract has any of the following as an underlying.
815-10-15-59 to 15-62)
• A climatic or geological variable or other physical
variable.
• The price or value of a nonfinancial asset or
nonfinancial liability of one of the parties to the
contract that meets certain conditions.
• Specified volumes of sales or service revenues of
one of the parties to the contract.

Derivative instruments The seller or A freestanding or embedded derivative whose existence

that impede sales transferor and serves as an impediment to recognizing a related
accounting (ASC 815- buyer contract as a sale by one party or a purchase by the
10-15-63 to 15-64) other party.

Investments in life The investor A policyholder’s investment in a life insurance contract

insurance (ASC 815- (e.g., corporate-owned life insurance and bank-owned
10-15-67) life insurance) that is accounted for in accordance with
ASC 325-30.

Certain investment The investor The following type of investments of a defined benefit
contracts (ASC 815-10- plan:
15-68 to 15-68A)
• Investments accounted for under ASC 960-325-35-
1.
• Insurance contracts accounted for under ASC 960-
325-35-3.

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JANUARY 2023

Scope Exception Can apply to: Description of contracts scoped out

Certain loan The lender All commitments that a lender makes to originate a loan
commitments (ASC other than a commitment for a mortgage loan that will be
815-10-15-69 to 15-71) held for sale.
The borrower Any loan commitment held by a borrower.

Certain interest-only The issuer and Interest-only strips and principal-only strips that result
strips and principal-only investor from separating a debt instrument into (a) an instrument
strips (ASC 815-10-15- that entitles its holder to receive payments associated
72 to 15-73) with the repayment of the principal of the debt
instrument and (b) an instrument that entitles its holder
to receive payments associated with the payments of
interest on the principal balance of the debt instrument.

Certain contracts The issuer of the • Contracts issued or held by a reporting entity that
involving an entity’s underlying are both indexed to its own stock and classified in
own equity (ASC 815- shares, with the stockholders’ equity
10-15-74 to 15-78) exception of the
• Contracts subject to ASC 718
third bullet point
which may apply • Certain contracts to enter into a business
to both parties combination, or acquisition by, or merger of, a not-
for-profit entity
• Certain forward contracts that require the reporting
entity to deliver cash in exchange for the acquisition
of a fixed number of its equity shares

Leases (ASC 815-10- The lessor and A lease that is within the scope of ASC 840 or ASC 842.
15-79) lessee

Residual value The party who A residual value guarantee that is within the scope of
guarantees (ASC 815- accounts for the ASC 840 or ASC 842.
10-15-80 to 15-81) residual value
guarantee under
ASC 840 or ASC
842

Registration payment Both parties to A registration payment arrangement within the scope of
arrangements (ASC the arrangement ASC 825-20.
815-10-15-82)

Certain fixed-odds The casino or A fixed-odds wagering contract within the scope of ASC
wagering contracts entity with casino 606 for an entity operating as a casino and for the
(ASC 815-10-15-82A) operations casino operations of other entities.

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JANUARY 2023

2.3.1 Regular-way security trades

The following definition and example of regular-way security trades are provided in ASC 815-10-15-15.
Regular-way security trades are defined as contracts that provide for delivery of a security within the
period of time (after the trade date) generally established by regulations or conventions in the
marketplace or exchange in which the transaction is being executed. For example, a contract to
purchase or sell a publicly traded equity security in the United States customarily requires settlement
within three business days. If a contract for purchase of that type of security requires settlement in
three business days, the regular-way security trades scope exception applies, but if the contract
requires settlement in five days, the regular-way security trades scope exception does not apply unless
the reporting entity is required to account for the contract on a trade-date basis.
A typical purchase or sale of a security would generally meet the definition of a derivative from its trade
date until the purchase or sale is settled if net settlement exists (e.g., contractually, through delivery of a
security that is readily convertible to cash or through a market mechanism). However, the FASB did not
intend for an entity to account for such transactions as derivatives between their trade and settlement
dates. For this reason, the regular-way security trades scope exception was established. Neither the
purchaser nor seller of a security account for a contract that meets the conditions of the regular-way
security trades scope exception in ASC 815-10-15-15 to 15-20 as a derivative.
An entity must understand the customary settlement period as well as the regulations and marketplace
conventions of the relevant market as this understanding is crucial to determine whether contracts to
purchase or sell securities qualify for this exception. In the U.S., the standard settlement cycle for most
broker-dealer security trades at the time of this publication is within two business days (practice had been
three days prior to amended Rule 15c6-1(a) of the Securities Exchange Act of 1934 which became
effective in September of 2017.) In February 2022, the SEC issued a proposed rule which would shorten
the standard settlement cycle for most broker-dealer transactions from two business days after trade to
one. The guidance in ASC 815-10-15-15 was not amended for the change in standard settlement cycles.
However, we believe it is important for an entity to consider current regulations and conventions in the
marketplace or exchange in which the transaction is being executed when determining if this scope
exception applies.
Further discussion of which transactions may qualify for the regular-way security trades scope exception
is provided in ASC 815-10-15-16 and 15-17.
Except as provided in (a) in the following paragraph, a contract for an existing security does not qualify
for the regular-way security trades scope exception if either of the following is true:
a. It requires or permits net settlement (as discussed in paragraphs 815-10-15-100 through 15-109).
b. A market mechanism exists to facilitate net settlement of that contract (as discussed in
paragraphs 815-10-15-110 through 15-118).
This scope exception for regular-way security trades applies only to a contract that requires delivery of
securities that are readily convertible to cash except that this scope exception also shall or may apply
in any of the following circumstances:
a. If an entity is required, or has a continuing policy, to account for a contract to purchase or sell an
existing security on a trade-date basis, rather than a settlement-date basis, and thus recognizes
the acquisition (or disposition) of the security at the inception of the contract, then the entity shall
apply the regular-way security trades scope exception to that contract.
b. If an entity is required, or has a continuing policy, to account for a contract for the purchase or
sale of when-issued securities or other securities that do not yet exist on a trade-date basis,
rather than a settlement-date basis, and thus recognizes the acquisition or disposition of the
securities at the inception of the contract, that entity shall apply the regular-way security trades
scope exception to those contracts.

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Entities can generally make an accounting policy election to account for sales (and purchases) of
securities on either the trade date or settlement date. Trade date accounting is required for brokers and
dealers, investment companies and depository and lending institutions, as well as certain benefit plans.
Because trading securities are accounted for at fair value with changes in fair value reported in earnings,
an entity that applies trade date accounting would not record a derivative instrument between the trade
date and settlement date.
2.3.1.1 “When-issued” or “to-be announced” (TBA) securities
Some securities are purchased on what is commonly referred to as a “when-issued” basis. That is, at the
time of purchase, the security does not exist, but there is a contractual agreement to deliver the security
at a later date when it is issued. A common example of this would be the purchase of mortgage-backed
securities that will arise from a planned securitization. In accordance with ASC 815-10-15-17(c), a
contract to purchase or sell a when-issued security or another security that does not yet exist is a regular-
way security trade and is excluded from the requirements of ASC 815 if it meets the following conditions.
• There is no other way to purchase or sell that security.
• Delivery of that security and settlement will occur within the shortest period possible for that type
of security.
• It is probable at inception and throughout the term of the individual contract that the contract will
not settle net and will result in physical delivery of a security when it is issued. (The entity shall
document the basis for concluding that it is probable that the contract will not settle net and will
result in physical delivery.)
An entity should document its rationale for concluding that it is probable both at inception and throughout
the life of the contract that it will result in physical delivery, not net settlement. An entity’s subsequent
decision to net settle contracts to which it originally applied the regular-way security trades scope
exception would call into question the entity’s application of this exception to other similar contracts.
Contrary to the guidance in ASC 815-10-15-16, which applies to contracts to purchase or sell securities
that are in existence, the guidance provided in ASC 815-10-15-19 for the purchase or sale of when-
issued securities or other securities that do not yet exist indicates that such transactions are eligible for
the regular-way security trades scope exception (as discussed in ASC 815-10-15-17) even if either of the
following are true:
• That contract permits net settlement (as discussed in paragraphs 815-10-15-100 through 15-109)
• A market mechanism exists to facilitate net settlement of that contract (as discussed in
paragraphs 815-10-15-110 through 15-118)
A to-be-announced (TBA) security may offer a choice of settlement dates. Example 9 beginning in
ASC 815-10-55-118 illustrates the application of this scope exception in such a circumstance.

Example 2.3.1: Regular-Way Security Trades-Shortest-Period Criterion (from ASC 815-10-55-118

to 55-120)
This Example illustrates the application of paragraph 815-10-15-17(c). Assume a variety of forward
contracts exists for a when-issued security, such as a to-be-announced security, that provides a
choice of settlement dates for each of the next three months (such as November, December, or
January). An entity enters into a forward contract to purchase the to-be-announced security, which
will otherwise meet the qualifications of paragraphs 815-10-15-13 through 15-20, that requires
delivery in the second-nearest month (such as December), not the nearest month (such as
November). The entity may not apply the regular-way security trade exception to the forward
purchase contract that requires delivery of the to-be-announced security in the second-nearest
month (such as December).

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In this Example, the to-be-announced security (identified by issuer, contractual maturity of the
underlying loans, and the net coupon, such as 30-year Government National Mortgage Association
[GNMA] securities bearing interest of 7%) is available under multiple settlement periods (that is, the
standardized settlement date in November, December, or January). The regular-way security trade
exception may be applied only to forward contracts for that to-be-announced security that require
delivery in November, the shortest period permitted for that type of to-be-announced security. The
December and January settlement to-be-announced forward contracts must be accounted for as
derivative instruments under this Subtopic.
If the forward contracts in this Example meet the hedge accounting criteria, they may be designated
in cash flow hedges of the anticipated purchase of the securities, as discussed in paragraph 815-20-
25-22.

2.3.1.2 Repurchase agreements, wash sales and short sales

ASC 815-10-55-56 addresses repurchase agreements and wash sales whereby a security is transferred
in a transaction that is accounted for as a sale and the transferor is obligated and entitled to repurchase
the transferred security at a fixed or determinable price. Generally, the repurchase element of these
transactions requires derivative treatment if the net settlement characteristic of a derivative is met.
Short sales of securities (also referred to as sales of borrowed securities) typically involve all of the
following activities (noted in ASC 815-10-55-57), generally documented in three separate contracts:
a. Selling a security (by the short seller to the purchaser)
b. Borrowing a security (by the short seller from the lender)
c. Delivering the borrowed security (by the short seller to the purchaser)
d. Purchasing a security (by the short seller from the market)
e. Delivering the purchased security (by the short seller to the lender).
As noted in ASC 815-10-55-58 and 55-59, these arrangements typically do not constitute derivatives.
However, may if there is a forward purchase or sale involved that does not qualify for the regular-way
security trades scope exception.
2.3.2 Normal purchases and normal sales
It is not uncommon for a contract to buy or sell a fungible asset like a commodity to meet the definition of
a derivative. However, the FASB did not intend for contracts that result in the delivery of a commodity or
other asset in quantities that are to be used or sold in the normal course of an entity’s business to be
accounted for as derivatives. This is why the FASB established the normal purchases and normal sales
scope exception.
A contract that meets the conditions of the normal purchases and normal sales scope exception in
ASC 815-10-15-22 to15-51 is not required to be accounted for as a derivative under ASC 815. This is the
only scope exception in ASC 815 that is optional and one of the conditions to take advantage of this
scope exception is to document the designation of the contract as a normal purchase or normal sale.
Although the designation may be made at inception or a later date, the proper documentation must be
prepared contemporaneously with the application of the scope exception. If the designation is made after
inception, a contract that meets all the characteristics of a derivative is accounted for as a derivative until
the designation is made.
The following explanation of what constitutes normal purchases and normal sales is provided in ASC 815-
10-15-22.
Normal purchases and normal sales are contracts that provide for the purchase or sale of something
other than a financial instrument or derivative instrument that will be delivered in quantities expected to
be used or sold by the reporting entity over a reasonable period in the normal course of business.

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Given the preceding explanation, an entity seeking to take advantage of this derivative scope exception
should assess the quantities subject to a purchase or sales contract considering the operational
requirements of its business. Although the preceding guidance refers to selling in the normal course of
business, we believe that the normal purchases and normal sales scope exception does not apply to
trading activities where the objective is to make a profit on market price movements.
Consistent with ASC 815-10-15-23 and 15-39, an entity performs the overall assessment as to whether a
contract qualifies for the normal purchases and normal sales scope exception at the inception of the
contract or at the date the entity decides to elect to account for that contract as a normal purchase or
normal sale, if later. However, as noted in ASC 815-10-15-35, an entity needs to consider whether it
remains probable that a contract that has contractual net settlement provisions or a market mechanism
for net settlement will result in physical delivery of the asset and not net settle on an ongoing basis.
This scope exception may be available to both the buyer and seller. As described in ASC 815-10-15-24,
the buyer and seller could come to different conclusions related to whether they qualify for the scope
exception. For example, the seller may expect the quantities that are subject to the contract to be sold
over a reasonable period in the normal course of business, but the buyer may not expect to use the
quantities over a reasonable period in the normal course of business or vice versa. Additionally, even if
both parties qualify for the scope exception, they may make different decisions about whether they want
to elect it. An example follows:
A-1 Manufacturer enters into long-term purchase contracts with its oil supplier that have all the
characteristics of a derivative to lock in a fixed oil price for quantities that are reflective of its expected
future needs. A-1 Manufacturer does not want the income statement volatility associated with carrying
these contracts as derivative assets or liabilities and continuously adjusting the carrying amounts to fair
value through earnings. A-1 Manufacturer therefore designates the contracts as normal purchase
contracts as discussed in ASC 815-10-15-37 after verifying that it meets all the requirements to do so.
In addition to entering into fixed price contracts to sell oil to its customers like A-1 Manufacturer, A-1’s oil
supplier also enters into derivative futures contracts to lock in its purchase price of oil and protect its
gross margin. A-1’s oil supplier decides not to designate the contracts with A-1 Manufacturer as normal
sales contracts as it prefers to account for these contracts as derivatives so that the earnings impact from
adjusting the carrying amount of these contracts to fair value through earnings offsets the earnings impact
of accounting for the related futures contracts as derivatives at fair value through earnings.

Typical commodity contracts

If the normal purchases and normal sales scope exception is properly elected and applied (i.e., all of
the required conditions, including documentation requirements are met), typical contracts for the
purchase or sale of commodities, inventory and other nonfinancial assets are not required to be
accounted for as derivatives under ASC 815 even if the contract otherwise meets the definition of a
derivative. Instead, reporting entities should look to other relevant GAAP including, ASC 606, Revenue
From Contracts with Customers when accounting for sale contracts. As it relates to purchase contracts,
ASC 330-10-35-17 requires an entity to recognize a net loss for firm unhedged inventory purchase
commitments (measured the same way as inventory losses).

The conditions that must be met to apply the normal purchases and normal sales scope exception are
described in further detail in the subsequent sections. These conditions relate to the following:
• Normal terms
• Clearly and closely related underlying
• Probable physical settlement

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• Documentation
2.3.2.1 Normal terms
A contract must have normal terms to qualify for the normal purchases and normal sales scope
exception. A basic premise underlying the normal purchases and normal sales scope exception is that the
terms of a contract must be consistent with an entity’s normal purchases or normal sales. This means that
the quantity to be purchased or sold must be reasonable in relation to the entity’s business needs, as
indicated in ASC 815-10-15-27. These determinations require judgment.
ASC 815-10-15-28 to 15-29 provide the following guidance for determining whether a contract includes
normal terms in relation to an entity’s business requirements.
In making those judgments, an entity should consider all relevant factors, including all of the following:
a. The quantities provided under the contract and the entity's need for the related assets
b. The locations to which delivery of the items will be made
c. The period of time between entering into the contract and delivery
d. The entity's prior practices with regard to such contracts
Further, each of the following types of evidence should help in identifying contracts that qualify as
normal purchases or normal sales:
a. Past trends
b. Expected future demand
c. Other contracts for delivery of similar items
d. An entity's and industry's customs for acquiring and storing the related commodities
e. An entity's operating locations
For guidance on normal purchases and normal sales as hedged items, see paragraph 815-20-25-7.
As an example, an entity may conclude that a forward contract to purchase two tons of steel would be for
quantities that it expects to use over a reasonable period in the normal course of its business if it normally
enters into contracts to purchase two tons of steel, has consistently used those quantities in its
manufacturing process within a reasonable period of time, and expects demand to be stable. However, if
that same entity entered into a contract to purchase two tons of steel at a time when it expected future
demand to be much lower, the entity may conclude that the contract would not qualify for the normal
purchases and normal sales scope exception because it would not have terms that are normal in relation
to its business needs. However, in coming to this conclusion, the entity would have to apply its judgement
and consider the factors and evidence as described in the guidance in ASC 815-10-15-28 to 15-29. When
determining if the quantity to be purchased or sold is reasonable in relation to the entity’s business needs,
an entity would need to consider its purchase or sales contracts in the aggregate in comparison to its
needs.
A contract that does not contain normal terms as previously described does not qualify for the normal
purchases and normal sales scope exception. A contract that contains normal terms must also meet all of
the other conditions in ASC 815-10-15-30 to 15-51 that are applicable to qualify for this scope exception.
2.3.2.2 Clearly and closely related underlying
Although purchase or sale contracts for items like commodities that will be used or sold in the normal
course of business often specify a fixed price, contracts may also have variable pricing or fixed pricing
that includes an adjustment based on a market index or other factor. The pricing in the contract must be
“clearly and closely related” to the asset being purchased or sold as noted in ASC 815-10-15-30 for the
contract to qualify for the normal purchases and normal sales scope exception. The term “clearly and

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closely related” means something different in this context than it does in the context of assessing whether
an embedded derivative requires bifurcation (Refer to Chapter 3 for a discussion on embedded
derivatives). For example, if a contract to sell jet fuel contains a price formula tied to a crude oil index, the
pricing in the contract would be considered “clearly and closely related” to the asset being sold because
jet fuel is refined from crude oil. On the other hand, if the pricing of the jet fuel was tied to the equity
shares of airlines, the contract would fail to meet the “clearly and closely related underlying” condition.
ASC 815-10-15-31 provides the following guidance on analyzing the phrase “clearly and closely related.”
For purposes of determining whether a contract qualifies for the normal purchases and normal sales
scope exception, the application of the phrase not clearly and closely related to the asset being sold or
purchased shall involve an analysis of both qualitative and quantitative considerations.
ASC 815-10-15-32 presents the following three situations in which the “clearly and closely related”
condition is not met. As a result, a contract that contains any of these price adjustments would not qualify
for the normal purchases and normal sales scope exception.
a. The underlying is extraneous (that is, irrelevant and not pertinent) to both the changes in the cost
and the changes in the fair value of the asset being sold or purchased, including being
extraneous to an ingredient or direct factor in the customary or specific production of that asset.
b. If the underlying is not extraneous as discussed in (a), the magnitude and direction of the impact
of the price adjustment are not consistent with the relevancy of the underlying. That is, the
magnitude of the price adjustment based on the underlying is significantly disproportionate to the
impact of the underlying on the fair value or cost of the asset being purchased or sold (or of an
ingredient or direct factor, as appropriate).
c. The underlying is a currency exchange rate involving a foreign currency that meets none of the
criteria in paragraph 815-15-15-10(b) for that reporting entity.
Guidance for evaluating a contractual price adjustment that is based on the change in the fair value of the
asset being purchased (sold) is provided in ASC 815-10-15-33.
For example, in the case in which the price adjustment focuses on the changes in the fair value of the
asset being purchased or sold, if the terms of the price adjustment are expected, at the inception of the
contract, to affect the purchase or sales price in a manner comparable to the outcome that would be
obtained if, at each delivery date, the parties were to reprice the contract amount under the then-
existing conditions for the asset being delivered on that date, the price adjustment’s underlying is
considered to be clearly and closely related to the asset being sold or purchased and the price
adjustment would not be an impediment to the contract qualifying for the normal purchases and normal
sales scope exception.
A contract that does not meet the clearly and closely related underlying condition does not qualify for the
normal purchases and normal sales scope exception. A contract that does meet the clearly and closely
related underlying condition must also meet all of the other conditions of the normal purchases and
normal sales scope exception (i.e., the conditions in ASC 815-10-15-27 to 15-29 and 15-35 to 15-51 that
are applicable to qualify for this scope exception).
2.3.2.3 Probable physical settlement
For contracts that have contractual net settlement provisions or a market mechanism for net settlement, it
must be probable at inception and throughout the term of the contract that the contract will not settle net
and will result in physical delivery to qualify for the normal purchases and normal sales scope exception.
This condition is provided in ASC 815-10-15-35.
For a contract that meets the net settlement provisions of paragraphs 815-10-15-100 through 15-109
and the market mechanism provisions of paragraphs 815-10-15-110 through 15-118 to qualify for the
normal purchases and normal sales scope exception, it must be probable at inception and throughout
the term of the individual contract that the contract will not settle net and will result in physical delivery.

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ASC 815-10-15-36 states that the normal purchases and normal sales scope exception may only be
applied to a contract that results in physical delivery of the item under that contract. An entity may not
apply this scope exception to a derivative that requires cash settling gains or losses or other periodic
settlements of gains or losses because such settlements are considered net settlements. (An example of
this would be a futures contract).
If it is not probable at inception and throughout its term that a contract with a contractual net settlement
provision or a market mechanism for net settlement will not settle net and will result in physical delivery, it
does not qualify for the normal purchases and normal sales scope exception. A contract that is probable
of physical settlement must also meet all the other conditions of the normal purchases and normal sales
scope exception (i.e., the conditions in ASC 815-10-15-27 to 15-34 and 15-37 to 15-51 to qualify for this
scope exception).
ASC 815-10-15-41 states in part that “net settlement (as described in paragraphs 815-10-15-100 through
15-109 and 815-10-15-110 through 15-118) of contracts in a group of contracts similarly designated as
normal purchases and normal sales would call into question the classification of all such contracts as
normal purchases or normal sales.” In practice, calling into question similarly designated contracts has
been referred to as “tainting.”
We believe that an entity should analyze the underlying reason(s) that caused a contract designated as a
normal purchase or normal sale to settle net. If an entity chooses to net settle a contract because for
example it wanted to benefit from favorable market price changes, we believe this would clearly call into
question the classification of similar contracts designated as normal purchases and sales. However, if the
entity was forced to net settle a contract due to the occurrence of an unexpected event that was outside
of its control and other similarly designated contracts were not affected in the same manner by that event,
the settlement of that one contract may not call into question the classification of other similar contracts
designated as normal purchases and normal sales. We believe the entity should clearly document its
justification for newly classifying or continuing to maintain the classification of similarly designated
contracts as normal purchases or normal sales.
2.3.2.4 Documentation
It is clear from ASC 815-10-15-38 that the designation of a contract as a normal purchase or normal sale
must be documented properly for an entity to apply this scope exception. ASC 815-10-15-39 allows an
entity to document this designation at contract inception or subsequently (in which case the contract
would be accounted for as a derivative until the designation is made). Once an entity documents its
compliance with the conditions of the normal purchases and normal sales scope exception, it cannot
voluntarily revoke the designation. However, as described in Section 2.3.2.3 of this chapter, an entity may
lose the ability to apply this scope exception.
In accordance with ASC 815-10-15-39, the documentation of the normal purchase normal sales scope
exception should demonstrate compliance with all relevant requirements in ASC 815-10-15-22 to 15-51.
If a contract does not meet these documentation requirements, it does not qualify for the normal
purchases and normal sales scope inception. A contract that meets the documentation requirements
must also meet all the other conditions in ASC 815-10-15-27 to 15-36A and 15-40 to 15-51 that are
applicable to qualify for the normal purchases and normal sales scope exception.
2.3.2.4.1 Level of application
ASC 815-10-15-38 allows the documentation requirements associated with the normal purchases and
normal sales scope exception to be applied to either an individual contract or a group of similar contracts.
It is important to adequately describe the contract or similar contracts to which the normal purchases and
sales scope exception is being applied.

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Practical considerations for designating a contract or group of contracts as a normal purchase

or normal sale
An entity may put in place a process (e.g., a standard template to be updated each time a contract is
entered into) for documenting the contracts it is designating as normal purchases and normal sales
along with the date of the designation to make it clear which contracts the designation pertains to and
the date the designation became effective. For forward contracts, this documentation should include
the rationale for determining that the contract will result in physical delivery and not settle net. For
contracts designated as power purchase or sales agreements, this documentation should include the
basis for concluding that the agreement meets the conditions in ASC 815-10-15-45 to 15-51 to apply
this scope exception, including the basis for concluding that the agreement is a capacity contract. In
addition, in accordance with ASC 815-10-15-39, the documentation of the normal purchase normal
sales scope exception should demonstrate compliance with all relevant requirements in ASC 815-10-
15-22 to 51.
Rather than complying with the documentation requirements at the specific contract level, entities could
consider designating groups of similar contracts collectively as normal purchases and normal sales
contracts. For example, clearly describing through an accounting policy the type of qualifying contracts
that will be designated as normal purchases or sales upon their origination, along with the rationale for
determining the contracts meet all relevant requirements could be a way to designate groups of similar
contracts collectively as normal purchases and normal sales contracts.

2.3.2.5 Futures contracts

A futures contract may be physically settled (i.e., the purchaser may take delivery of the item it purchased
at the settlement of the contract). However, futures exchanges commonly require daily cash settlements
to cover the net gain or loss position of the derivative, which make a futures contract ineligible for the
normal purchases and normal sales scope exception pursuant to ASC 815-10-15-36.
2.3.2.6 Contracts with optionality features
Rather than entering forward contracts that commit the parties to purchase or sell a stated quantity of a
certain item, entities may enter purchases or sales contracts that give them the option to purchase or sell
certain quantities of an item. Additionally, a forward contract might contain an optionality feature
permitting the purchaser to adjust the quantity of the asset to be delivered under the contract. For
example, to meet its business need for corn, an entity may enter into a forward contract to buy 10,000
bushels of corn with an option to buy an additional 5,000 bushels at $4 per bushel. Contracts with
optional quantities generally are not eligible for the normal purchases and normal sales scope exception.
This is because at contract inception, it cannot be determined that physical delivery is probable to occur
because delivery is contingent on exercise of the option. Exceptions to the general rule are explained in
ASC 815-10-15-42, ASC 815-10-55-24 and 55-28 to 55-29 whereby a forward contract with an option to
adjust the quantity of the asset to be delivered may qualify for the normal purchases and normal sales
scope exception if one of the following conditions exist:
• The contract is a power purchase or sales agreement as discussed in ASC 815-10-15-45 to 15-51
(Refer to Section 2.3.2.7.1 of this chapter)
• The option component permits the holder only to purchase (sell) additional quantities at the market
price on the delivery date
If the optionality feature that allows for quantity adjustments expires or is exercised and the forward
contract has not settled, the contract may then qualify for the normal purchases and normal sales scope
exception because the uncertainty as to the quantity to be delivered no longer exists, as discussed in
ASC 815-10-15-43.

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A forward contract that provides optionality features that modify something other than the quantity of the
asset to be delivered (e.g., the price) may qualify for the normal purchases and normal sales scope
exception.
ASC 815 provides the following example regarding the normal purchases and normal sales scope
exception and forward contracts that contain optionality features.

Example 2.3.2: Normal Purchases and Normal Sales—Application to Forward Contracts that
Contain Optionality Features (from ASC 815-10-55-121 to 55-131)
In some circumstances, an option may be combined with a forward contract. In some instances, the
optionality feature in the forward contract can modify the quantity of the asset to be delivered under
the contract. In other cases, the optionality feature in the forward contract can modify only the price
to be paid or the timing of the delivery.
This Example presents three Cases of forward contracts with optionality features:
a. Optionality feature involving price floor (cash-settled put option) written by purchaser and price
cap (cash-settled call option) written by seller (Case A)
b. Optionality feature involving cash-settled put option written by purchaser (Case B)
c. Optionality feature involving physically settled put option written by purchaser (Case C)
In Cases A, B, and C, the optionality feature must be analyzed to determine whether it could modify
the quantity of the asset to be delivered under the contract. In doing so, the conclusion as to
whether the contract is eligible for the normal purchases and normal sales scope exception applies
in the same way to both counterparties—the purchaser and the writer of the option (within the
forward contract).
The contracts addressed in this Example do not have a price based on an underlying that is not
clearly and closely related to the asset being purchased, nor do they require cash settlement of
gains or losses as stipulated in paragraph 815-10-15-22.
Paragraph 815-10-15-43 explains that, if the optionality feature in the forward contract can modify
the quantity of the asset to be delivered under the contract, but that option feature has expired or
has been completely exercised (even if delivery has not yet occurred), there is no longer any
uncertainty as to the quantity to be delivered under the forward contract. That paragraph explains
that, following such expiration or exercise, the forward contract would be eligible for designation as a
normal purchase or normal sale, provided that the other conditions in paragraph 815-10-15-22 are
met.
Case A: Optionality Feature Involving Price Floor (Cash-Settled Put Option) Written by
Purchaser and Price Cap (Cash-Settled Call Option) Written by Seller
Entity A enters into a forward contract to purchase on a specified date a specified quantity of a raw
material that is readily convertible to cash. The purchase price is the current market price on the
date of purchase, not to exceed a specified maximum price (a cap) nor to be less than a specified
minimum price (a floor).
In this Case, the optionality feature cannot modify the quantity to be delivered; thus, the contract is
eligible to qualify for the normal purchases and normal sales scope exception.
Case B: Optionality Feature Involving Cash-Settled Put Option Written by Purchaser
Entity B enters into a forward contract to purchase on a specified date a specified quantity of a raw
material that is readily convertible to cash. The contract’s purchase price is a fixed amount per unit
that is below the current forward price; however, if the market price on the date of purchase has
fallen below a specified level, Entity B’s purchase price would be adjusted to a higher fixed amount
significantly in excess of the current forward price at the inception of the contract. (The contract
entered into by Entity B is a compound derivative consisting of a forward contract to purchase raw

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material at the original fixed price and a written option that obligates Entity B to purchase the raw
material for the higher adjusted price if the market price of the raw material falls below the specified
level. In exchange for the written option, Entity B received a premium representing the difference
between the purchase price in the contract and the forward market price of the raw material at the
inception of the contract.)
The forward purchase contract in this Case is eligible to qualify for the normal purchases and normal
sales scope exception because the optionality feature in the contract cannot modify the quantity to
be delivered.
Case C: Optionality Feature Involving Physically Settled Put Option Written by Purchaser
Entity C enters into a forward contract to purchase on a specified date a specified quantity of a raw
material that is readily convertible to cash. The contract’s purchase price is a fixed amount per unit
that is below the current forward price. However, if the market price on the date of purchase has
fallen below a specified level that is below the contract’s fixed purchase price, Entity C would be
required to purchase a specified additional quantity of the raw material at the contract’s fixed
purchase price (which is above the current market price on the date of purchase). (The contract
entered into by Entity C is a compound derivative consisting of a forward contract to purchase raw
material at the original fixed price and a written option that obligates Entity C to purchase additional
quantities of the raw material at an above-market price if the market price of the raw material falls
below the specified level.)
The contract in this Case is not eligible to qualify for the normal purchases and normal sales scope
exception because the optionality feature in the contract can modify the quantity of the asset to be
delivered under the contract.

Contracts that Combine a Forward Contract and a Purchased Option Contract

• As explained in ASC 815-10-55-26, an entity cannot separate a forward contract with an optionality
feature into two derivatives— one that is an option that does not qualify for the scope exception
and another that is a forward contract without optionality that may qualify for the scope exception.
This is because an entity cannot separate a compound derivative into two or more derivatives.
• However, ASC 815-10-55-27 explains that an entity can enter into a forward contract and a
separate option contract that together can achieve the same economic results as a single
derivative instrument. The entity may then be able to apply the normal purchases and normal sales
scope exception to the forward contract.

• Similarly, as described in ASC 815-10- 55-30, if an entity has a single supply contract that is a
forward contract with optionality and later replaces that single contract with two contracts, one
being a forward contract for a fixed quantity and the other being an option contract for additional
quantities, the new forward contract may be eligible for the normal purchases and normal sales
scope exception. However, the option contract would not be eligible for this scope exception.

ASC 815-10-55-24 to 55-30 provide further guidance on accounting for forward contracts with optionality.
2.3.2.7 Electricity contracts
ASC 815-10-15-36A addresses the purchase (sale) of electricity on a forward basis and whether such
purchase (sale) with transmission services constitutes a series of sequential contracts intended to
accomplish the ultimate acquisition or sale of a commodity, and whether the use of locational marginal
pricing to determine transmission charges or credits constitutes net settlement.
Certain contracts for the purchase or sale of electricity on a forward basis that necessitate transmission
through, or delivery to a location within, an electricity grid operated by an independent system operator

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result in one of the contracting parties incurring charges (or credits) for the transmission of that
electricity based in part on locational marginal pricing differences payable to (or receivable from) the
independent system operator. For example, this is the case when the delivery location under the
contract (for example, a hub location) is not the same location as the point of ultimate consumption of
the electricity or the point from which the electricity exits the electricity grid for transmission to a
customer load zone. Delivery to the point of ultimate consumption or the exit point is facilitated by the
independent system operator of the grid. The purchase or sale contract and the transmission services
do not constitute a series of sequential contracts intended to accomplish the ultimate acquisition or
sale of a commodity as discussed in paragraph 815-10-15-41, and the use of locational marginal
pricing to determine the transmission charge (or credit) does not constitute net settlement, even in
situations in which legal title to the associated electricity is conveyed to the independent system
operator during transmission.
2.3.2.7.1 Power purchase or sales agreements
In the electric power industry, it is common for one party to purchase electricity from a sole provider.
Although some of these contracts require the delivery of a fixed quantity of power, others provide
optionality regarding the quantity of electricity to be delivered. The optionality provides the purchaser the
opportunity to meet fluctuating demand and may also be responsive to regulatory requirements. A unique
quality of electricity is that it cannot be easily stored. Because electricity cannot be easily stored and the
general requirement that an entity take physical delivery of the asset that is the subject of the contract to
which the normal purchases and normal sales scope exception would be applied, ASC 815 provides
guidance in ASC 815-10-15-45 to 15-51 for the application of this scope exception to power purchase or
sales agreements.
A power purchase or sales agreement may qualify for the normal purchases and normal sales scope
exception whether it is a forward contract, option contract, or a combination of a forward and option
contract if certain conditions are met. Those conditions are set forth in ASC 815-10-15-45 and 15-37 and
are summarized in the following table.

Conditions apply to Condition to be met

Both the purchaser The contract requires the physical delivery of electricity (i.e., net settlement is
and seller not permitted). If the contract is an option contract, physical delivery of
electricity is required upon exercise. The use of locational marginal pricing for
calculating transmission charges (or credits) does not equate to net settlement,
even in if legal title to the electricity is conveyed to the independent system
operator (ISO).

The contract must be a capacity contract. Judgment based on the facts and
circumstances is needed to distinguish between a capacity contract and a
financial option contract on electricity. When an entity analyzes power
purchase or sale agreements that contain optionality features it should
consider the characteristics discussed in ASC 815-10-55-31. However, other
characteristics may also be relevant to the analysis. Refer to the table below.

The entity must document why the contract qualifies for the normal purchases
and normal sales scope exception.

The purchaser The purchaser expects to use or sell the quantity of electricity that is
deliverable under the contract in its normal course of business.

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Conditions apply to Condition to be met

The purchaser engages in retail or wholesale sale of electricity to customers

and is obligated by statute or contract to maintain sufficient electricity capacity
to meet the needs of its customers.

The contract is entered into to meet the purchaser’s obligation to maintain a

sufficient electricity capacity. Such obligations could include a reasonable
reserve margin to comply with a regulatory commission, local standards,
regional reliability councils, or regional transmission organizations.

The seller The electricity that is deliverable under the contract must involve quantities that
the seller expects to sell in the normal course of its business.

Some of the concepts introduced in the preceding table are discussed in further detail in the following
subsections.
As discussed in ASC 815-10-15-47, forward contracts to purchase or sell electricity that do not meet all
the conditions in the preceding table may still qualify for the normal purchases and normal sales scope
exception if all the requirements for the scope exception other than ASC 815-10-15-45 are met and they
are not subject to unplanned netting (unplanned netting is referred to in the electric power industry being
booked out). See the following section on physical delivery of electricity.
Physical delivery of electricity
As explained in ASC 815-10-15-35, to qualify for the normal purchases and normal sales scope exception
if net settlement exists under the terms of a contract or through a market mechanism, it must be probable
at inception and throughout the term of the contract that the contract will not settle net and will result in
physical delivery. However, as indicated in ASC 815-10-15-45(a), physical delivery must be required for a
capacity contract to qualify for the normal purchases and normal sales scope exception. Therefore, we
believe that a capacity contract that contains a provision for market-based liquidating damages would not
qualify for the normal purchases and normal sales scope exception because the damages clause is a
form of net settlement. Certain power purchase or sale agreements allow for being booked out. A book
out occurs when an electricity entity nets offsetting transactions with the same counterparty (or group of
counterparties). Scheduled as well as unplanned book outs are common when two or more power entities
have offsetting transactions. A contract that contains a book out provision is not eligible for the normal
purchases and normal sales scope exception unless it is a capacity contract and meets the conditions in
the preceding table. Said another way, a power purchase or sales agreement that meets the conditions
described in the preceding table qualifies for the normal purchases and normal sales scope exception
even if it is subject to book out provisions.
Electricity wholesalers often join Regional Transmission Organizations (RTO). An RTO is an electric
power transmission system operator that controls, coordinates, and monitors an electric grid across
multiple states. The operations of the grid are managed by an ISO. The ISO is profit neutral and does not
generate, market, or trade power for itself. The transmission of electricity commonly involves contractual
delivery locations that differ from the location where the electricity is ultimately consumed or the point
from which it exits the grid to be transmitted to an end consumer. Typically, an ISO takes legal title to the
electricity for transmission through the grid and assigns prices to the electricity at locations on the grid
(otherwise known as nodes) where the electricity can be delivered and withdrawn. The price an ISO
charges for electricity typically includes any cost recovery as well as locational pricing differentials at the
delivery and withdrawal locations.
ASC 815-10-15-45 indicates that a contract is not considered to be net settled as a consequence of it:

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1. requiring delivery locations that differ from the location where the electricity is ultimately consumed or
the point from which the electricity exits the grid to be transmitted to a customer,
2. transferring the legal title of the electricity to the ISO during transmission, or
3. involving locational marginal pricing.
Capacity contract
For a contract with optionality to be considered a capacity contract such that it may be eligible for the
normal purchases and normal sales scope exception, it must meet the definition provided in ASC 815-10-
20.
An agreement by an owner of capacity to sell the right to that capacity to another party so that it can
satisfy its obligations. For example, in the electric industry, capacity (sometimes referred to as installed
capacity) is the capability to deliver electric power to the electric transmission system of an operating
control area.
Distinguishing an option contract that is a capacity contract from a financial (traditional) option contract
requires significant judgment based on facts and circumstances. The following table from ASC 815-10-
55-31 compares the characteristics of an option that is a capacity contract and a financial option contract
on electricity.

Option Contract That Is a Capacity Contract Financial Option Contract on Electricity

1 The contract usually specifies the power plant No reference is made to the generation
or group of power plants providing the origination of the electricity.
electricity.

2 The strike price (paid upon exercise) includes The strike price is structured based on the
pricing terms to compensate the plant operator expected forward prices of power.
for variable operations and maintenance costs
expected during the specified production
periods.

3 The specified quantity is based on individual The specified quantity reflects standard
needs of parties to the agreement. amounts of electric energy, which facilitate
market liquidity (for example, exercise in
increments of 10,000 kilowatt-hours).

4 The title transfer point is usually at one or a The specified index transfer point is a major
group of specified physical delivery point(s), as market hub (liquid trading hub), not seller-
opposed to a major market hub. or buyer-site specific.

5 The contract usually specifies certain No operational performance is specified

operational performance by the facility (for (not plant specific).
example, the achievement of a certain heat
rate).

6 The contract sometimes incorporates None specified.

requirements for interconnection facilities,
physical transmission facilities, or reservations
for transmission services.

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Option Contract That Is a Capacity Contract Financial Option Contract on Electricity

7 The contract may specify jointly agreed-to plant Penalties for outages are not specified (not
outages (for example, for maintenance) and plant specific).
provide for penalties in the event of
unexpected outages.

8 Damage provisions upon default are usually Damage provisions upon default are based
based on a reduction of the capacity payment on market liquidating damages.
(which is not market based). If default
provisions specify market liquidating damages,
they usually contain some form of floor, ceiling,
or both. The characteristics of the default
provision are usually tied to the expected
generation facility.

9 The contract’s term is usually long (one year or The contract’s term is not longer than 18 to
more). 24 months because financial options on
electricity are currently illiquid beyond that
period.

In accordance with ASC 815-10-15-49, the guidance on power purchase or sales agreements does not
impact the accounting for a requirements contract that does not meet the definition of a derivative
because for example it does not have a notional amount. As indicated in ASC 815-10-15-50, a contract
that qualifies for the normal purchases and normal sales scope exception based on the guidance on
power purchase or sales agreements is not required to comply with any additional guidance in ASC 815-
10-15-22 to 15-44 That is, the guidance summarized in Section 2.3.2 of this chapter exclusive of this
subsection on power purchases or sales agreements. However, a contract whose price is based on an
underlying that is not clearly and closely related to the electricity being purchased (sold) or that is
denominated in a foreign currency that does not meet the conditions in ASC 815-15-15-10(b) is not
eligible for the normal purchases and normal sales scope exception.
In accordance with ASC 815-10-15-51, the guidance on power purchase or sales agreements should not
be applied by analogy to contracts that do not meet the conditions in ASC 815-10-15-45.
2.3.2.8 Take-or-pay contracts
A take-or-pay contract is a contract whereby an entity agrees to purchase goods or services and pay for
them even if it does not take delivery of them. A take-or-pay contract may meet the definition of a
derivative and would qualify for the normal purchases and normal sales scope exception if all of the
relevant conditions are met.
2.3.2.8.1 Contracts that meet the definition of a derivative after inception
If a contract meets the definition of a derivative in ASC 815 after its initial recognition, an entity may apply
the normal purchases and normal sales scope exception as soon as it realizes the contract meets the
definition of a derivative. However, the entity will still have to meet the documentation and other
conditions of the normal purchases and normal sales scope exception.
2.3.3 Certain insurance contracts and upon the adoption of ASU 2018-12, market risk benefits
U.S. GAAP has long-standing accounting guidance for traditional insurance contracts. The FASB did not
intend to affect the accounting for these contracts by requiring them to be accounted for as derivatives.

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Specifically, neither the holder nor issuer of a contract that meets all of the following conditions provided
in ASC 815-10-15-52 should account for the contract as a derivative under ASC 815.
• The holder of the contract will only be compensated as the result of an identifiable insurable event
other than a change in price.
• Because of the identifiable insurable event, the holder incurs a liability or there is an unfavorable
change in the value of a specific asset or liability for which the holder is at risk.
• Payment of a claim is triggered only by a bona fide insurable exposure (i.e., the contract needs to
have an insurance component but as noted in a discussion that follows, there can also be a derivative
component).
• The contract must provide for a legitimate transfer of risk (i.e., a deposit or form of self-insurance
does not qualify).
Generally, insurance contracts that fall within the scope of ASC 944 would meet the conditions of the
insurance contract scope exception. If any of the preceding conditions are not met, this scope exception
does not apply.
We have observed that traditional life insurance contracts and traditional property and casualty insurance
contracts are the most common types of insurance contracts that are excluded from the guidance in
ASC 815 because of the insurance contract scope exception. The rationale for excluding traditional life
insurance contracts and traditional casualty insurance contracts from the guidance in ASC 815 is
provided in ASC 815-10-15-53, which is summarized in the following table.

Contract type Rationale as to why the contract is not subject to ASC 815

Life insurance The payment of death benefits is the result of an identifiable insurable event
(death of the insured) instead of changes in a variable.

Property and casualty The payment of benefits is the result of an identifiable insurable event (for
example, theft or fire) instead of changes in a variable.

A contract may be a combination of a derivative instrument and an insurance product or nonderivative

contract. An indexed annuity, a variable life insurance contract, a property and casualty contract with
foreign currency options and a nontraditional life insurance contract that is primarily an investment that
incidentally provides a death benefit are examples of insurance products that may have a derivative
component. An entity should evaluate such a contract to determine if it contains an embedded derivative
that is required to be accounted for separately as a standalone derivative instrument. Example 11 that
begins in ASC 815-10-55-132 discusses this scope exception in the context of a reinsurance contract
whereby the retention amount is adjusted downward based on a scale tied to the Dow Jones Industrial
Average. The death benefit component of an investment-like contract may be excluded from ASC 815.
Even if that is the case, an entity should assess the investment component to determine if it is subject to
the guidance in ASC 815. Refer to Chapter 3 for further information on embedded derivatives.
In accordance with ASC 815-10-15-55, a property and casualty insurance contract that provides for
benefits or claims as a result of both changes in a variable and an identifiable insurable event is not
subject to the guidance in ASC 815 in its entirety and does not contain an embedded derivative that
requires separate accounting if it meets the following conditions:
• Benefits or claims are paid under the contract only if an identifiable insurable event occurs (e.g., a
fire).
• The payment amount is limited to the amount of the policyholder’s incurred insured loss.

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• The contract does not involve essentially assured amounts of cash flows (regardless of the timing of
those cash flows) based on insurable events highly probable of occurring because the insured would
nearly always receive the benefits (or suffer the detriment) of changes in the variable.
ASC 815 provides the following example to illustrate a contract that involves essentially assured amounts
that do not qualify for the scope exception.

Example 2.3.3: Certain Insurance Contracts—Essentially Assured Amounts (from ASC 815-10-
55-134)
This Example illustrates the guidance in paragraph 815-10-15-55(c) for a contract involving
essentially assured amounts. Insured Entity has received at least $2 million in claim payments from
its insurance entity (or at least $2 million in claim payments were made by the insurance entity on
the insured entity's behalf) for each of the previous 5 years related to specific types of insured
events that occur each year. That minimum level of coverage would not qualify for the insurance
contract scope exclusion.

In accordance with ASC 815-10-15-56, the component of a contract that provides for an actuarially
determined minimum amount of expected claim payments resulting from insurable events that are
determined to be highly probable of occurring does not qualify for the insurance contract scope exception
if both of the following conditions are met:
• Those minimum payment cash flows are indexed to or altered by changes in a variable.
• Those minimum payment amounts are expected to be paid each policy year (or on another
predictable basis).
In these circumstances, the actuarially determined minimum amount of expected claim payments that are
highly probable of occurring is considered to be the minimum notional amount when performing the
embedded derivative analysis under ASC 815-15-25. Refer to Chapter 3 for further information on
embedded derivatives.

Insurable event versus a change in a price or index

One of the conditions that must be met for a contract to qualify for the insurance contract scope
exception is that benefits or claims are paid under the contract only if an identifiable insurable event
occurs.
To illustrate, a traditional property insurance contract whereby the policy holder receives benefits in the
event of fire or other damage to the property would meet this requirement. Conversely, a property
insurance contract that would pay benefits to the holder as a consequence of changes in a real estate
price index would not meet this requirement.

Certain property and casualty insurance contracts are referred to as dual-trigger policies because they
pay the holder benefits only if two events occur. One of the events is typically the occurrence of a
traditional insurable event and the other event is typically a change in a pre-identified variable such as a
climatic variable or the price of a commodity. Refer to ASC 815-10-55-37 to 55-40 and Example 11
beginning in ASC 815-10-55-132 for illustrations and the application of the accounting guidance to
policies of this type. Dual trigger contracts often qualify for either the insurance contract scope exception
or the nonfinancial asset scope exception to derivative accounting that is discussed later in this chapter.
2.3.4 Certain financial guarantee contracts
A financial guarantee is an agreement whereby one party guarantees a debt will be repaid by another
party if the obligor defaults. Many financial guarantee contracts meet the definition of a derivative.
However, the FASB created a scope exception so that certain financial guarantee contracts are not

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accounted for as derivatives. Specifically, neither the guaranteed party nor the guarantor account for a
contract that meets all of the following conditions in ASC 815-10-15-58 as a derivative under ASC 815.
a. They provide for payments to be made solely to reimburse the guaranteed party for failure of the
debtor to satisfy its required payment obligations under a nonderivative contract, either:
1. At prespecified payment dates
2. At accelerated payment dates as a result of either the occurrence of an event of default (as
defined in the financial obligation covered by the guarantee contract) or notice of acceleration
being made to the debtor by the creditor.
b. Payment under the financial guarantee contract is made only if the debtor’s obligation to make
payments as a result of conditions as described in (a) is past due.
c. The guaranteed party is, as a precondition in the contract (or in the back-to-back arrangement, if
applicable) for receiving payment of any claim under the guarantee, exposed to the risk of
nonpayment both at inception of the financial guarantee contract and throughout its term either
through direct legal ownership of the guaranteed obligation or through a back-to-back
arrangement with another party that is required by the back-to-back arrangement to maintain
direct ownership of the guaranteed obligation.
Paragraph A22 of Statement of Financial Accounting Standards No. 149—Amendment of Statement 133
on Derivative Instruments and Hedging Activities provides the following helpful insights.
…..Accordingly, the Board determined that, in order for a financial guarantee contract to qualify for the
scope exception in paragraph 10(d), the guaranteed party must demand payment from the debtor and
that once it is determined that the required obligation will not be satisfied by the debtor, the guaranteed
party must relinquish to the guarantor its rights to receive payment from the debtor in order to receive
payment from the guarantor. The Board also concluded that the language in paragraph 10(d) should
be clarified to eliminate use of the term loss incurred and instead focus on amounts due to the
guaranteed party but not paid by the debtor.
If any of the preceding conditions are not met, the financial guarantee scope exception does not apply.
The following table describes certain financial guarantees and whether they qualify for the financial
guarantee scope exception.

Description of the contract Financial guarantee scope exception

Credit default swap that requires a Does not apply. For a contract to qualify for the financial
payment due to unfavorable guarantee scope exception, it must provide for payments to be
changes in the credit rating of a made solely to reimburse the guaranteed party for failure of the
specified entity debtor to satisfy its required payment obligations. That is not the
case with a credit default swap that requires a payment upon an
unfavorable change in the credit rating of a specified entity.

A guarantee that requires the Does not apply. For a contract to qualify for the financial
guarantor to make a payment if the guarantee scope exception, it must provide for payments to be
specified party files for bankruptcy made solely to reimburse the guaranteed party for failure of the
debtor to satisfy its required payment obligations. That is not the
case with a guarantee that requires the guarantor to make a
payment solely as a consequence of the specified party filing for
bankruptcy.

A guarantee that requires the Does not apply. For a contract to qualify for the financial
guarantor to make a payment if the guarantee scope exception, it must provide for payments to be

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Description of the contract Financial guarantee scope exception

specified party violates a debt made solely to reimburse the guaranteed party for failure of the
covenant debtor to satisfy its required payment obligations. That is not the
case with a guarantee that requires the guarantor to make a
payment if the specified party violates a debt covenant. An entity
may violate a debt covenant without failing to satisfy its required
payment obligations.

A guarantee that requires the It depends. For a contract to qualify for the financial guarantee
guarantor to make a payment scope exception, it must provide for payments to be made solely
because a payment obligation to reimburse the guaranteed party for failure of the debtor to
under a nonderivative contract was satisfy its required payment obligations. That is, the payments
automatically accelerated due to under the guarantee can only be reimbursement for payments
the occurrence of a “nonpayment- that are both due and unpaid. A debtor whose payment
based” default (e.g., bankruptcy, schedule is accelerated because of a nonpayment default may
debt covenant violation, change in still make its payment under the accelerated schedule.
control)

A guarantee that requires the Does not apply. For a contract to qualify for the financial
guarantor to make a payment to the guarantee scope exception, the guaranteed party, at inception of
guaranteed party, regardless of the financial guarantee contract and throughout its term must be
whether the guaranteed party is exposed to the risk of nonpayment as a contractual precondition
exposed to a risk of nonpayment for receiving a claim payment under the guarantee. That is not
the case with a guarantee that requires the guarantor to make a
payment to the guaranteed party, regardless of whether the
guaranteed party is exposed to a risk of nonpayment.

A contract that promises to pay the Does not apply. For a contract to qualify for the financial
guaranteed party the difference guarantee scope exception, it must provide for payments to be
between a post-credit-event fair made solely to reimburse the guaranteed party for failure of the
value and the book value of an debtor to satisfy its required payment obligations. That is not the
asset case with a contract that requires the guarantor to pay the
guaranteed party the difference between a post-credit-event fair
value and the book value of an asset.

A contract that entitles the holder to It would apply if all the conditions in ASC 815-10-15-58 are met.
claims to the extent its credit losses The aforementioned limitations on the claims do not prevent the
exceed a specified minimum level, contract from qualifying for the scope exception. (Refer to the
further limited by the amount to example that begins in ASC 815-10-55-32).
which credit losses on a customized
pool or index of loans exceed that
minimum level

Credit derivatives that transfer It depends. Some credit derivatives do not require the party who
credit risk from one party to another purchased the credit protection to maintain a direct exposure to
party the referenced asset at contract inception and throughout the life
of the contract. In addition, they may provide for payments to be
made in circumstances that go beyond the debtor failing to
satisfy a required payment obligation. In these and other

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Description of the contract Financial guarantee scope exception

circumstances whereby all the conditions in ASC 815-10-15-58
are not met, the scope exception does not apply.

Financial guarantees and ASC 460

If a financial guarantee is excluded from ASC 815, the entity would consider the guidance in ASC 460 if
applicable to determine the appropriate recognition, measurement and disclosure requirements related
to the contract. Also, as elaborated on in ASC 460-10-50-1, certain disclosures required by ASC 460
are applicable to guarantees that are outside the scope of ASC 460 (e.g., guarantees accounted for as
derivatives in accordance with ASC 815, except for credit derivatives). In addition, ASC 944-20
provides accounting guidance for financial guarantees that are insurance contracts and reinsurance
contracts that do not meet the definition of a derivative that are issued by insurance entities.

2.3.5 Certain nonexchange traded contracts

ASC 815 provides the following four scope exceptions for certain contracts that are not traded on an
exchange.
• Climatic, geological, or other physical variable scope exception
• Nonfinancial asset scope exception
• Nonfinancial liability scope exception
• Specified volumes of sales or service revenues scope exception
These scope exceptions can apply to both parties to the nonexchange-traded contract.
The nature of the underlying upon which the settlement of a nonexchange-traded contract is based
determines whether the contract qualifies for one of the aforementioned scope exceptions. However, a
contract that meets the definition of a derivative in ASC 815 may have more than one underlying and not
every underlying may qualify for one of these scope exceptions. As explained in ASC 815-10-15-60 to 15-
61, determining whether a contract qualifies for one of the nonexchange-traded scope exceptions
depends on the contract’s predominant characteristics. This means that an entity should account for a
contract as a derivative if all of the contract’s underlyings, considered in combination, behave in a manner
that is highly correlated with the behavior of any of the contract’s component variables that do not qualify
for a scope exception.
For the purposes of the following discussion, the nonfinancial asset scope exception and the nonfinancial
liability scope exception are combined.
2.3.5.1 Climatic, geological or other physical variable
As noted in ASC 815-10-15-59(a), this scope exception applies to non-exchange-traded contracts
whereby the underlying on which settlement is based is a climatic, geological or other physical variable.
The following are examples of underlyings contained in certain contracts that may qualify for this scope
exception:
• Inches of rainfall (e.g., to hedge against a ruined crop)
• Inches of snowfall (e.g., to hedge against a bad ski season)
• Severity of earthquakes as measured by the Richter scale (e.g., to hedge against property casualty)

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• The category of hurricanes as measured by the Saffir-Simpson Hurricane Wind scale in a contract
(e.g., to hedge against property casualty)
• Temperature or average temperatures exceeding a certain degree for a particular number of days
(e.g., to hedge against poor heating oil sales because of a warm winter)
For this scope exception to apply, the contract must include an underlying that is based on a climatic,
geological, or other physical variable. It does not apply to a contract that has an underlying that is based
on a financial variable. The following table compares an underlying based on a climatic variable to an
underlying based on a financial variable.

Underlying based on a climatic variable Underlying based on a financial variable

A contract that requires the issuer to pay the A contract that requires the issuer to pay the
holder $250 million if a hurricane equal to or holder if hurricane damage in the northeast region
greater than Category 3 on the Saffir-Simpson of the U.S. during 2020 exceeds $250 million. The
Hurricane Wind Scale occurs in the northeast underlying is the occurrence of damage that
region of the U.S. during 2020. The underlying is exceeds $250 million, which is a financial variable.
the occurrence of a hurricane of the specified Therefore, this contract does not qualify for this
magnitude. Given the occurrence of a hurricane is scope exception.
a climatic variable, this contract qualifies for this
However, a contract that requires the issuer to
scope exception.
reimburse the holder for the dollar amount of
damages that the holder incurred as a result of a
hurricane would likely qualify for the insurance
contract scope exception discussed in Section
2.3.7 of this chapter.

Example 13 in ASC 815-10-55 illustrates the difference between physical and financial variables for
purposes of applying the scope exception in ASC 815-10-15-59(a).

Example 2.3.4: Certain Contracts that Are Not Traded on an Exchange—Distinguishing Between
Physical and Financial Variables (from ASC 815-10-55-135 to 55-141)
The following Cases illustrate the difference between physical and financial variables for purposes
of applying the scope exception in paragraph 815-10-15-59(a):
a. Contract containing both a physical variable and a financial variable (Case A)
b. Contract containing only a physical variable (Case B)
c. Contract containing only a financial variable (Case C).
Case A: Contract Containing Both a Physical Variable and a Financial Variable
A contract’s payment provision specifies that the issuer will pay to the holder $10,000,000 if
aggregate property damage from all hurricanes in the state of Florida exceeds $50,000,000 during
the year 2001.
In this Case, the payment under the contract occurs if aggregate property damage from all
hurricanes in the state of Florida exceeds $50,000,000 during the year 2001. The contract contains
two underlyings—a physical variable (that is, the occurrence of at least one hurricane) and a
financial variable (that is, aggregate property damage exceeding a specified or determinable dollar
limit of $50,000,000). Because of the presence of the financial variable as an underlying, the
derivative instrument does not qualify for the scope exclusion in paragraph 815-10-15-59(a).
Case B: Contract Containing Only a Physical Variable

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A contract specifies that the issuer pays the holder $10,000,000 in the event that a hurricane occurs
in Florida in 2001.
If a contract contains a payment provision that requires the issuer to pay to the holder a specified
dollar amount that is linked solely to a climatic or other physical variable (for example, wind velocity
or flood-water level), paragraph 815-10-15-59(a) provides that the contract is not subject to the
requirements of this Subtopic.
In this Case, the payment provision is triggered if a hurricane occurs in Florida in 2001. The
underlying is a physical variable (that is, occurrence of a hurricane). Therefore, the contract qualifies
for the scope exclusion in paragraph 815-10-15-59(a).
Case C: Contract Containing Only a Financial Variable
A contract would be a traditional insurance contract that is excluded from the scope of this Subtopic
under the exception discussed beginning in paragraph 815-10-15-52 if the contract requires a
payment only if the holder incurs a decline in revenue or an increase in expense as a result of an
event (for example, a hurricane) and the amount of the payoff is solely compensation for the amount
of the holder’s loss.

Weather derivatives that qualify for this scope exception may be within the scope of ASC 815-45.
2.3.5.2 Nonfinancial asset or liability
A contract that is not traded on an exchange for which the underlying on which settlement is based is a
nonfinancial asset or liability may qualify for a scope exception under either ASC 815-10-15-59(b) or 15-
59(c).
Under ASC 815-10-15-59(b), the underlying on which settlement is based is:
The price or value of a nonfinancial asset of one of the parties to the contract provided that the asset is
not readily convertible to cash. This scope exception applies only if both of the following are true:
1. The nonfinancial assets are unique.
2. The nonfinancial asset related to the underlying is owned by the party that would not benefit
under the contract from an increase in the fair value of the nonfinancial asset. (If the contract is a
call option, the scope exception applies only if that nonfinancial asset is owned by the party that
would not benefit under the contract from an increase in the fair value of the nonfinancial asset
above the option’s strike price.)
Under ASC 815-10-15-59(c), the underlying on which settlement is based is:
The fair value of a nonfinancial liability of one of the parties to the contract provided that the liability
does not require delivery of an asset that is readily convertible to cash.

Reassessment of the nonfinancial asset or liability scope exception

We believe that an entity should periodically reevaluate the application of the nonfinancial asset or
liability scope exception because for a contract to qualify, the underlying asset cannot be considered
readily convertible to cash. As internet-based marketplaces continue to develop, we expect that more
assets will be readily convertible to cash.

If any of the relevant preceding conditions are not met, the nonfinancial asset or liability scope exception
does not apply.
An entity cannot apply the nonfinancial asset scope exception to a contract if the nonfinancial assets that
are subject to the contract are interchangeable or fungible units because the assets subject to the
contract would not be unique.
The following are some examples of nonfinancial assets that we believe may be considered unique:

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• A landmark building in a city

• A parking lot associated with a sports arena
• A unique work of art
• A specialty manufactured good
• A special ordered part of an automobile, aircraft, or watercraft, etc.
The preceding list is not meant to be all inclusive.
2.3.5.2.1 Equity kicker
A lender may make a loan to a borrower so that the borrower can acquire an operating property that
grants the lender the right to participate in the profit from the sale of the property or its refinancing.
Similarly, a lender may make a loan to a borrower to help the borrower finance its operations that grants
the lender the right to participate in a certain portion of the borrower’s operations. These rights within
loans to participate in the profit from the sale or refinancing of the property or to participate in a portion of
the borrower’s operations are referred to as embedded equity kickers. An equity kicker (whether
embedded in a loan agreement or not) typically qualifies for the nonfinancial asset scope exception in
ASC 815-10-15-59(b) or the specified volumes of sales or service revenues scope exception in ASC 815-
10-15-59(d) (discussed later). This is explained in ASC 815-15-55-10 as follows.
Under paragraph 815-10-15-59(b), an embedded equity kicker would typically not be subject to the
requirements of this Subtopic because the separate instrument with the same terms is not exchange
traded and is indexed to nonfinancial assets that are not readily convertible to cash. If an equity kicker
is based on a share in net earnings or operating cash flows, it would also typically qualify for the scope
exception in paragraph 815-10-15-59(d). If the embedded derivative does not need to be accounted for
separately under this Subtopic, the Acquisition, Development and Construction Arrangements
Subsections of Subtopic 310-10 shall be applied.
Purchase options for unique properties are a common example of contracts that qualify for the
nonfinancial asset scope exception assuming all the criteria are met. Another example of how this scope
exception may come into play is provided in ASC 815-15-55-8 to 55-9.

Example 2.3.5: Participating mortgage (from ASC 815-15-55-8 to 55-9)

Under an example participating mortgage, the investor receives a below-market interest rate and is
entitled to participate in the appreciation in the fair value of the project that is financed by the mortgage
upon sale of the project, at a deemed sale date, or at the maturity or refinancing of the loan. The
mortgagor must continue to own the project over the term of the mortgage.
The instrument has a provision that entitles the investor to participate in the appreciation of the
referenced real estate (the project). However, a separate contract with the same terms would be
excluded by the exception in paragraph 815-10-15-59(b) because settlement is based on the value of
a nonfinancial asset of one of the parties that is not readily convertible to cash. (This Subtopic does
not modify the guidance in Subtopic 470-30).

Example 14 in ASC 815-10-55 that follows illustrates how for this scope exception to apply, the asset
must be unique and owned by the party that would not benefit under the contract if the asset increased in
price or value.

Example 2.3.6: Certain Contracts that Are Not Traded on an Exchange—Nonfinancial Asset of
One of the Parties to a Contract (from ASC 815-10-55-142 to 55-143)
Entity A enters into a non-exchange-traded forward contract to buy from Entity B 100
interchangeable (fungible) units of a nonfinancial asset that are not readily convertible to cash. The

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contract permits net settlement through its default provisions. Entity A already owns more than 100
units of that nonfinancial asset, but Entity B does not own any units of that nonfinancial asset.
The scope exception in paragraph 815-10-15-59(b) does not apply to the accounting for the contract
for both of the following reasons:
a. The contract’s settlement is based on an underlying associated with a nonfinancial asset that is
not unique (because it is based on the price or value of an interchangeable, nonfinancial unit).
b. The entity that owns the nonfinancial asset related to the underlying (that is, Entity A) is the
buyer of the units and thus would benefit from the forward contract if the price or value
increases.
Consequently, neither Entity A nor Entity B qualifies for the scope exception in paragraph 815-10-
15-59(b).

2.3.5.3 Specified volumes of sales or service revenues

A contract that is not traded on an exchange for which the underlying on which settlement is based is
specified volumes of sales or service revenues of one of the parties to the contract is not accounted for as
a derivative under ASC 815-10-15-59(d).
Specified volumes of sales or service revenues of one of the parties to the contract. (This scope
exception applies to contracts with settlements based on the volume of items sold or services
rendered, for example, royalty agreements. This scope exception does not apply to contracts based on
changes in sales or revenues due to changes in market prices.)
If the preceding conditions are not met, the specified volumes of sales or service revenues scope
exception does not apply.
The underlying premise for this scope exception is that a contract that provides for settlements that are
based on sales volume or service revenues of one of the parties to the contract was not intended to be
accounted for as a derivative. A lease contract may contain a clause whereby the tenant must pay the
landlord a percentage of its monthly sales as a component of the lease payment. Another common
example is a royalty agreement contract that requires a franchisee to pay the franchisor a specified rate
based the sales volume of the franchisee. While this scope exception does not apply to payments based
on changes in sales or revenues due to changes in market prices, it is evident from the example in ASC
815-15-55-10 that in addition to volume of sales or service revenues, the scope exception applies to
payments based on a portion of net earnings or operating cash flows.

Sales and revenues underlying

ASC 815-10-15-59(d) notes that the specified volumes of sales or service revenues scope exception
does not apply to “contracts based on changes in sales or revenues due to changes in market prices”.
However, we believe the FASB did not intend to prohibit the application of this exception to royalty
arrangements that require payments based on changes in revenues that are due to changes in market
prices when such changes are applied to the volume of items sold or services rendered. As a result, we
believe that the conditions for the specified volumes of sales or service revenues scope exception can
be satisfied by royalty arrangements that require payments based on changes in either sales or
revenues that are due to both changes in per unit market prices and in the number of units.

2.3.6 Derivative instruments that impede sale accounting

ASC 815-10-15-63 explains that a freestanding or embedded derivative like a call option may qualify for
this scope exception if the existence of the potential derivative impedes the recognition of a related
contract as a sale. An example would be an entity that sells loans and has an option to purchase them
back. This call option may prevent the transfer of the loans from being accounted for as a sale under

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ASC 860, in which case the loans would remain on the entity’s statement of financial position. A call
option associated with a failed sale would qualify for this scope exception so an entity would not account
for the loans twice—once through the recognition of the loan and the other through the recognition of the
option. This scope exception applies to the transferor and transferee in a transfer that is subject to
ASC 860.
Pursuant to ASC 815-10-15-63, a derivative that is held by a transferor that is related to assets that were
transferred as part of a transaction that is accounted for as a financing in accordance with ASC 860, but
which does not itself impeder sale accounting, is not within the scope of ASC 815 if recognizing the
derivative and either the transferred asset or liability brought about by the transfer results in accounting
for the same thing twice in the transferor’s statement of financial position. However, if recognizing the
derivative and either the transferred asset or liability brought about by the transfer would not result in
accounting for the same thing twice in the transferor’s statement of financial position, the derivative would
be in the scope of ASC 815.
The following table describes certain potential derivatives and whether they qualify for the sales
accounting impediment scope exception.

Applicability of the sales accounting impediment

Description of the potential derivative scope exception

Cleanup call—an option held by the servicer An arrangement that meets the definition of a cleanup
or its affiliate, which may be the transferor, to call option in ASC 860-10-20 does not impede sale
purchase the remaining financial assets, or accounting in accordance with ASC 860-10-40-34.
the remaining beneficial interests not held by Therefore, the scope exception would not apply
the transferor, its affiliates, or its agents in an unless the transfer was accounted for as a financing
entity (or in a series of beneficial interests in for other reasons such that recognizing both the
transferred financial assets within an entity) if cleanup call as a derivative and the transferred asset
the amount of outstanding financial assets or would be double counting the assets on the statement
beneficial interests falls to a level at which the of financial position.
cost of servicing those assets or beneficial
interests becomes in relationship to the
benefits of servicing.

A call option (other than a cleanup call) that Applies. The call option will cause the transfer to fail to
gives a transferor the unilateral right to meet the condition in ASC 860-10-40-5(c) and
repurchase transferred financial assets that therefore impede sale accounting. In general, if a
are not readily obtainable. derivative instrument is an impediment to recognizing
the sale of a financial asset (from a related contract),
that derivative instrument is specifically excluded from
ASC 815. This scope exception avoids the problem of
double counting that would occur if the transferred
financial asset was not derecognized and a derivative
instrument was recognized.

A derivative that a transferor holds that relates In accordance with ASC 815-10-15-64, a derivative
to financial assets transferred in a transaction instrument should not be accounted for as a derivative
that it accounted for as a secured borrowing under ASC 815 if recognizing both the derivative and
in accordance with ASC 860, but which does either the transferred asset or liability that arose from
not itself serve as an impediment to sale the transfer would result in the transferor accounting
accounting for the same item twice.

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An illustration of the application of this scope exception is provided in ASC 815-10-55-41.

2.3.7 Investments in life Insurance
Pursuant to ASC 815-10-15-67, a policyholder’s investment in a life insurance contract (e.g., corporate-
owned life insurance and bank-owned life insurance) that is accounted for in accordance with ASC 325-
30 is not accounted for as a derivative under ASC 815. This scope exception only applies to the holder of
the life insurance contract.
2.3.8 Certain investment contracts
There is guidance within ASC 960 that addresses the accounting for certain investment contracts. For
practical reasons, the FASB excluded these investment contracts from ASC 815 and thus, from being
accounted for as derivatives. As explained in ASC 815-10-15-68, this scope exception applies only to the
following investment contracts:
• Plan investments accounted for under ASC 960-325-35-1
• Insurance contracts accounted for under ASC 960-325-35-3
The investment contract scope exception applies only to the holder of the investment contract, not the
issuer of the investment contract.
2.3.8.1 Synthetic guaranteed investment contracts
As the name implies, a synthetic guaranteed investment contract is a financial instrument that simulates
the performance of a guaranteed investment contract. An in-depth discussion of these contracts is
included in ASC 815-10-05-8 through 05-15 and an illustration of their contractual terms is included
beginning in ASC 815-10-55-169. ASC 815-10-55-63 indicates that an issuer of a synthetic guaranteed
investment contract is required to account for it as a derivative. However, as noted in ASC 815-10-15-
68A, the wrapper of a synthetic guaranteed investment contract that meets the definition of a fully benefit-
responsive investment contract that is held by an employee benefit plan is exempt from ASC 815.
2.3.9 Certain loan commitments
Loan commitments may meet the definition of a derivative. However, the FASB did not intend for all loan
commitments to be accounted for as derivatives.
As explained in ASC 815-10-15-69, with one exception, neither a lender nor a borrower accounts for a
loan commitment as a derivative. The exception is that lenders are required to account for loan
commitments to originate mortgage loans that it will hold for sale as derivatives.
SEC Staff Guidance incorporated in ASC 815-10-S99-1 provides the SEC Staffs’ views on certain
questions related to measuring the fair value of derivative loan commitments. That is, the staff believes
that the expected net future cash flows associated with servicing the related loan should be included in
the fair value measurement of the derivative loan commitment, However expected net future cash flows
related to internally-developed intangible assets should not be so included.
As noted in ASC 815-10-15-70, the loan commitment scope exception does not apply to a commitment to
purchase or sell loans at a future date. An entity must evaluate such a commitment to determine if it
meets the definition of a derivative. Such a commitment often is a derivative that would be subject to ASC
815 if net settlement exists (e.g., because the loans that are subject to the commitment can be readily
converted to cash).
2.3.10 Certain interest-only strips and principal-only strips
Interest-only strips (I/Os) and principal-only strips (P/Os) result from separating a debt instrument into
(a) an instrument that is entitled to receive payments associated with the repayment of the principal of the
debt instrument (the P/O) and (b) an instrument that is entitled to receive payments associated with the

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payments of interest on the principal balance of the debt instrument (the I/O). ASC 815 provides a narrow
scope exception for simple I/Os and P/Os. The parties to an I/O or P/O strip that meets both of the
following conditions, which are listed in ASC 815-10-15-72, do not account for it as a derivative under
ASC 815:
a. It represents the right to receive only a specified proportion of the contractual interest cash flows of
a specific debt instrument or a specified proportion of the contractual principal cash flows of that
debt instrument.
b. It does not incorporate any terms not present in the original debt instrument.
I/O strips and P/O strips can be a form of compensation to a servicer as discussed in ASC 860. As
ASC 815-15-55-154 illustrates, both servicing fees in excess of adequate compensation and guarantee
fees are examples of circumstances that cause an I/O or P/O strip to not qualify for this scope exception.
This as well as the guidance in ASC 815-10-15-73 are reinforced in the following table.

Applicability of the
I/O and P/O scope
Description of I/O strip or P/O strip exception

A portion of the interest or principal cash flows of a specific debt instrument as Applies
reasonable compensation for stripping the debt instrument.

A portion of the interest or principal cash flows of a specific debt instrument as Applies
adequate compensation to a servicer (as defined in AS 860).

A portion of the interest or principal cash flows of a specific debt instrument to Does not apply
provide for a guarantee of payments.

A portion of the interest or principal cash flows of a specific debt instrument to Does not apply
provide for servicing in excess of adequate compensation.

A portion of the interest or principal cash flows of a specific debt instrument for Does not apply
any other purpose.

2.3.11 Certain contracts involving an entity’s own equity

One of the basic principles of ASC 815 is that a derivative instrument represents rights or obligations that
meet the definitions of assets or liabilities. As an extension of that notion, items classified as equity are
not accounted for as derivatives. The primary scope exception guidance is in ASC 815-10-15-74 to 15-78.
The following guidance in ASC 815-10-15-74 outlines the types of contracts that qualify for the scope
exception for certain contracts involving an entity’s own equity:
Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall
not consider the following contracts to be derivative instruments for purposes of this Subtopic:
a. Contracts issued or held by that reporting entity that are both:
1. Indexed to its own stock (see Section 815-40-15)
2. Classified in stockholders’ equity in its statement of financial position (see Section 815-40-25)
b. Contracts issued by the entity that are subject to Topic 718. If any such contract ceases to be
subject to Topic 718 in accordance with paragraphs 718-10-35-9 through 35–14, the terms of that
contract shall then be analyzed to determine whether the contract is subject to this Subtopic. An

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award that ceases to be subject to Topic 718 in accordance with those paragraphs shall be
analyzed to determine whether it is subject to this Subtopic.
c. Any of the following contracts:
1. A contract between an acquirer and a seller to enter into a business combination
2. A contract to enter into an acquisition by a not-for-profit entity
3. A contract between one or more NFPs to enter into a merger of not-for-profit entities
d. Forward contracts that require settlement by the reporting entity’s delivery of cash in exchange for
the acquisition of a fixed number of its equity shares (forward purchase contracts for the reporting
entity’s shares that require physical settlement) that are accounted for under paragraphs 480-10-
30-3 through 30-5, 480-10-35-3, and 480-10-45-3.
As explained in ASC 815-10-15-75, the scope exceptions in the preceding paragraph do not apply to
either of the following:
a. The counterparty in those contracts. For example, the scope exception in (b) in the preceding
paragraph related to stock-based compensation arrangements does not apply to equity
instruments (including stock options) received by nonemployees as compensation for goods and
services.
b. A contract that an entity either can or must settle by issuing its own equity instruments but that is
indexed in part or in full to something other than its own stock. That contract can be a derivative
instrument for the issuer under paragraphs 815-10-15-13 through 15-139, in which case it would
be accounted for as a liability or an asset in accordance with the requirements of this Subtopic.
For example, a forward contract that is indexed to both an entity’s own stock and currency
exchange rates does not qualify for the exception in (a) in the preceding paragraph with respect
to that entity’s accounting because the forward contract is indexed in part to something other than
that entity’s own stock (namely, currency exchange rates).
The remainder of this section discusses the own equity scope exception as it relates to:
• Contracts that are indexed to an entity’s own stock and are classified in stockholders’ equity
• Contracts subject to ASC 718
• Contracts to facilitate a business combination
• Fixed-for-fixed forward contracts
2.3.11.1 Contracts that are indexed to an entity’s own stock and are classified in stockholders’
equity
In accordance with ASC 815-10-15-74(a), a contract that an entity issued or holds that is indexed to its
own stock and is required to be presented in stockholders’ equity (whether permanent or temporary) is
exempt from ASC 815. Refer to RSM’s Guide to Accounting for Debt and Equity Instruments in Financing
Transactions Sections 5.2.2.1 and 5.2.2.2 for determining whether a contract is both:
• Indexed to the issuer’s own stock
• Classified in stockholders’ equity in the issuer’s statement of financial position
2.3.11.2 Contracts subject to ASC 718
In accordance with ASC 815-10-15-74(b), a stock-based compensation arrangement that is within the
scope of ASC 718 is not accounted for as a derivative under ASC 815. As a result, an entity that issues
share-based payment awards that are within the scope of ASC 718, including stock options, stock
warrants, and restricted stock to employees and (or) nonemployees (including customers) in exchange for
goods or services does not account for those awards as derivatives. However, such an award would be

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accounted for as a derivative by the recipient if it possesses all of the characteristics of a derivative
because this scope exception applies only to the employer and not the recipient.
As noted in ASC 815-10-55-46 to 55-48, stock awards that relate to the stock of an unrelated entity are
not within the scope of ASC 718 even if the vesting of the awards is subject to continued employment.
and therefore, do not qualify for this scope exception to ASC 815.
In accordance with ASC 718-10-35-10 through 35-12, a freestanding financial instrument issued to a
grantee that is originally subject to ASC 718 may become subject to other accounting guidance, including
ASC 815 if the terms of that instrument are modified after the grantee is no longer an employee or after
the grantee vests in the award and is no longer providing goods or services or is no longer a customer.
As such, in circumstances like this, an entity should consider whether the modified instrument is a
derivative and if so, whether it meets the scope exception in ASC 815-10-15-74(a) for contracts that are
indexed to an entity’s own stock and are classified within stockholders’ equity.
2.3.11.3 Contracts to facilitate a business combination
In accordance with ASC 815-10-15-74(c), the parties to the following contracts do not account for them as
derivatives:
• A contract between an acquirer and a seller to enter into a business combination
• A contract to enter into an acquisition by a not-for-profit entity
• A contract between one or more NFPs to enter into a merger of not-for-profit entities
Although the preceding types of contracts typically do not meet the definition of a derivative, they are
nonetheless explicitly scoped out of ASC 815.
While contracts to enter into a business combination or certain acquisitions or mergers are excluded from
the scope of ASC 815, an entity should evaluate contracts or instruments that it issues or acquires in
conjunction with the acquisition or merger to determine whether they are derivatives in their entirety or
contain embedded derivatives that it should account for as derivatives in accordance with ASC 815. This
evaluation includes considering whether the contracts or instruments meet the definition of a derivative
and if any of the scope exceptions discussed in this section apply. An entity should determine this based
on the facts and circumstances that exist at the date of the acquisition.
As part of this evaluation, an entity should analyze any contingent consideration feature in a business
combination to determine whether it meets the definition of a derivative in ASC 815. An entity should also
consider the scope exception for certain contracts involving an entity’s own equity for any share-based
consideration. For further information on accounting for contingent consideration in a business
combination refer to RSM’s A Guide to Accounting for Business Combinations Section 12.4.
2.3.11.4 Fixed-for-fixed forward contracts
In accordance with ASC 815-10-15-74(d), a forward contract that requires settlement whereby the
reporting entity will deliver cash in exchange for a fixed number of its equity shares that is accounted for
under ASC 480-10-30-3 to 30-5 is not accounted for as a derivative under ASC 815. For further
information on accounting for such forward contracts refer to RSM’s Guide to Accounting for Debt and
Equity Instruments in Financing Transactions.
2.3.12 Leases
In accordance with ASC 815-10-15-79, the lessor and lessee of a lease that is within the scope of
ASC 840 or ASC 842 for the reporting entity do not account for the lease as a derivative under ASC 815.
However, the lease may contain features that are embedded derivatives and require separate accounting
as required by ASC 815-15-25-1. Refer to Chapter 3 of this guide for further information on embedded
derivatives.

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2.3.13 Residual value guarantees

To protect their economic interest in a leased asset, lessors commonly require lessees to guarantee that
the value of the leased asset will be at least a certain amount at the end of the lease term when the
lessee returns the asset to the lessor. Such guarantees are referred to as residual value guarantees. In
accordance with ASC 815-10-15-80, a residual value guarantee that is within the scope of ASC 840 or
ASC 842 is not accounted for as a derivative under ASC 815.
Sometimes a third-party (e.g., an insurance company) may provide a residual guarantee to a lessor on
behalf of the lessee. As discussed in ASC 815-10-15-81, the third-party guarantor considers the guidance
in ASC 815 for any residual value guarantee that it provides to determine whether the guarantee meets
the definition of a derivative, and if so, whether it meets the residual value guarantee scope exception in
ASC 815. If the residual value guarantee is not accounted for as a derivative under ASC 815, the
guarantor should consider whether the guarantee falls within the scope of ASC 460.
2.3.14 Registration payment arrangements
Registration rights or registration payment arrangements entitle the holder (e.g., investor or lender) to
require an entity to file a registration statement for the resale of its equity instruments. A lender may
receive registration rights in conjunction with the issuance of a loan agreement that can be settled in
shares. Registration rights may also be granted in conjunction with the issuance or sale of equity, a
warrant agreement, or convertible debt agreement. These registration rights may entitle the holder to an
additional interest or payment if the entity does not file a registration statement by a certain date or allows
it to lapse.
Guidance is provided in ASC 825-20 for issuers of registration payment arrangements. This guidance
requires separate recognition and measurement under ASC 450 of the contingent obligation to make
future payments (or transfer consideration) under a registration payment arrangement. This is the case
regardless of whether the obligation arises from a separate agreement or is included as a feature of the
debt or equity instrument. In accordance with ASC 815-10-15-82, neither the issuer nor its counterparty
(e.g., investor or lender) of a registration payment arrangement that is within the scope of ASC 825-20
would account for it as a derivative under ASC 815.
2.3.15 Certain Fixed-Odds Wagering Contracts
In accordance with ASC 815-10-15-82A, a fixed-odds wagering contract for an entity operating as a
casino and for the casino operations of other entities are within the scope of ASC 606; and therefore, is
not accounted for as a derivative.

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3. Embedded derivatives
3.1 Overview
As noted in ASC 815-15-05-1, contracts such as bonds, insurance policies, leases and preferred stock
may contain embedded derivatives. In other words, an instrument or contract that is not a derivative in its
entirety may contain a feature(s) that have the same or similar economic effect(s) as a derivative
instrument. An entity may be required to bifurcate an embedded derivative from the instrument in which it
is contained and account for it separately unless the entity elects to account for the entire instrument
under the fair value option. The FASB’s rationale for issuing guidance on embedded derivatives is to
prevent an entity from avoiding the derivative accounting requirements of ASC 815 by inserting a
derivative feature in a nonderivative instrument or other contract.
Although the concepts in the preceding paragraph are not difficult to understand, in practice, an entity is
often presented with one or more challenges in applying the accounting guidance for embedded
derivatives. These challenges essentially stem from the fact that an embedded derivative is an
accounting construct. That is, whereas a freestanding interest rate swap or forward contract is itself a
contractual agreement with specified terms, an embedded derivative is not. Rather, for lack of a better
term, it is embedded in another instrument or contract. This means that identifying an embedded
derivative will not always be apparent. ASC 815 defines an embedded derivative as “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.” Analyzing whether an embedded derivative exists requires
judgment. In addition, once an entity identifies that an instrument or contract contains an embedded
derivative, the terms of the embedded derivative may not always be obvious. Moreover, not only is an
entity required to evaluate the terms of its instruments or contracts to identify potential embedded
derivatives, it must also determine whether any embedded derivatives that it identified require separate
accounting. Making these determinations requires careful analysis and management judgment. The
process to determine if an embedded feature requires separate accounting is multi-faceted. To illustrate,
an embedded feature is not accounted for separately as a derivative unless it meets the definition of a
derivative under ASC 815 and does not meet any of the scope exceptions. Also, if the instrument or
contract that contains the embedded derivative is accounted for at fair value with the changes in its fair
value recorded in earnings, the embedded derivative is not separated because essentially it is already
receiving the accounting treatment that it would receive if it would be accounted for separately. This is
because the terms that comprise the embedded derivative would need to be considered when
determining the fair value of the instrument or contract in which the embedded derivative is contained.
Finally, an embedded derivative is not accounted for separately unless its economic characteristics and
risks are not clearly and closely related to the economic characteristics and risks of its host contract.
Comparing the economic characteristics and risks of the embedded derivative to the economic
characteristics and risks of the host contract requires not only identifying and understanding the nature of
the embedded derivative, but also requires understanding the nature of the host contract. Determining the
nature of the host contract is oftentimes a subjective assessment. Consider an instrument that has been
determined to contain an equity-like embedded derivative. If the host contract is more akin to equity, then
the economic characteristics and risks of the equity-like embedded derivative would be clearly and closely
related to those of the host contract and the embedded derivative would not be accounted for separately.
Conversely, if the host contract is more akin to debt, then the economic characteristics and risks of an
embedded equity-like derivative would not be considered clearly and closely related to that of the host
contract and if the other required conditions are met, the embedded feature would be accounted for
separately as a derivative. This chapter explores all of these concepts in more depth.

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Accounting for embedded derivatives

If it is determined that an embedded derivative requires separate accounting, it is accounted for as if it
is a freestanding derivative. That is, the embedded derivative is initially and subsequently reported and
measured on the statement of financial position at fair value as determined pursuant to ASC 820. The
change in the fair value of the embedded derivative is reported in earnings unless the derivative is
designated as a hedging instrument in a cash flow or net investment hedge. (Refer to Chapter 3 for
additional guidance on the accounting for embedded derivatives and to RSM’s A Guide to Hedge
Accounting Upon the Adoption of ASU 2017-12 for further guidance on hedge accounting).

3.1.1 Embedded derivative terminology

When determining whether an embedded feature must be accounted for as a derivative, it is important to
understand the following terms:

Term Description

Hybrid instrument A contract that embodies both an embedded derivative and a host contract.

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. As explained by ASC 815-15-25-2, embedded derivative refers
to provisions noted in a single contract and not to provisions within separate
contracts between different counterparties

Host contract The component of the hybrid instrument other than the embedded derivative.

Embedded derivative An embedded derivative that requires bifurcation from the host contract and
that requires separate is accounted for as a separate derivative instrument because it meets the
accounting conditions in ASC 815-15-25-1 that are discussed later in this chapter.

The following example demonstrates how this guidance is applied to similar instruments, namely, a
warrant to purchase shares and an option to obtain shares by converting debt or preferred stock. If facts
and circumstances differ from those included in this example, a different conclusion may be reached.

Stock purchase Warrants are generally considered to be freestanding even if issued with
warrants another financial instrument, such as debt or stock. That is because warrants
are typically separately exercisable (i.e., the exercise of the warrants would not
result in the termination of the debt or stock the warrants may have been
issued with).

Conversion options in Conversion options are typically viewed as embedded in the convertible debt
debt or preferred or preferred stock because the conversion option generally cannot be
stock agreements detached and separately exercised (i.e., the exercise of the conversion option
would result in the termination of the debt or preferred stock that is converted).

3.1.2 Scope exceptions

In addition to the general scope exceptions summarized in ASC 815-10-15-13 and discussed in
Chapter 2 of this guide that may be relevant to embedded derivatives, ASC 815-15 provides for certain
scope exceptions that are specific to embedded derivatives. The circumstances under which embedded

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derivatives would not require separate accounting are outlined in ASC 815-15-15-4 to 15-21 and are
summarized in the table that follows.

Contract, transaction Conditions that must be met to be exempt from the guidance on
or feature embedded derivatives

Normal purchases and A contract that qualifies for the normal purchases and normal sales scope
normal sales contracts exception discussed at Section 2.3.2 of Chapter 2 is not considered to
(ASC 815-15-15-4) contain an embedded derivative.

Unsettled foreign Unsettled foreign currency transactions, including financial instruments,

currency transactions contain embedded foreign currency derivatives if the transactions meet all
(ASC 815-15-15-5 to the following:
15-6)
a. They are monetary items.
b. They have their principal payments, interest payments, or both
denominated in a foreign currency.

c. They are subject to the requirement in Subtopic 830-20 to recognize any

foreign currency transaction gain or loss in earnings.
ASC 815-15-15-6 clarifies that this exception applies to foreign-currency
denominated trading and available-for-sale securities. We believe that this
exception applies to financial instruments that are not securities as well.

Plain-vanilla servicing Plain-vanilla servicing rights, which involve the obligation to service assets
rights (ASC 815-15-15- and the right to receive fees for that servicing, do not contain an embedded
7) derivative requiring separate accounting.

Features involving The transfer of credit risk that is created by the subordination of one financial
certain aspects of credit instrument or tranche to another potentially creates an embedded derivative.
risk (ASC 815-15-15-9) This scope exception from derivative treatment applies only to an embedded
credit derivative created by subordination. Other embedded credit
derivatives such as credit default swaps on a referenced credit exposure are
potentially subject to separate derivative accounting even if their effects are
allocated across various tranches of securitized financial instruments for
subordination purposes. Consequently, the following circumstances (among
others) would not qualify for this scope exception and would potentially be
subject to separate derivative accounting:
a. An embedded derivative feature relating to another type of risk (including
another type of credit risk) is present in the securitized financial
instruments.

b. The holder of an interest in a tranche of that securitized financial instrument

is exposed to the possibility (however remote) of being required to make
potential future payments (not merely receive reduced cash inflows)
because the possibility of those future payments is not created by
subordination. (Note, however, that the securitized financial instrument may
involve other tranches that are not exposed to potential future payments
and, thus, those other tranches might qualify for the scope exception.)

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Contract, transaction Conditions that must be met to be exempt from the guidance on
or feature embedded derivatives
c. The holder owns an interest in a single-tranche securitization vehicle;
therefore, the subordination of one tranche to another is not relevant.

Features involving An embedded foreign currency derivative is not separated from its host
certain currencies (ASC contract and accounted for separately as a derivative if the following
815-15-15-10 to 15-21) conditions in ASC 815-15-15-10 are met:
a. The host contract is not a financial instrument.
b. The host contract requires payment(s) denominated in any of the
following currencies:
1. The functional currency of any substantial party to that contract
2. The currency in which the price of the related good or service
that is acquired or delivered is routinely denominated in
international commerce (for example, the U.S. dollar for crude
oil transactions)
3. The local currency of any substantial party to the contract
4. The currency used by a substantial party to the contract as if it
were the functional currency because the primary economic
environment which the party operates is highly inflationary (as
discussed in paragraph 830-10-45-11)
c. Other aspects of the embedded foreign currency derivative are
clearly and closely related to the host contract.
The evaluation of whether a contract qualifies for the exception in this
paragraph should be performed only at inception of the contract.
While this scope exception does not apply to financial instruments, it applies
to a normal insurance contract that involves payment in the functional
currency of either of the two parties to the contract. In addition, it applies to a
normal insurance contract that involves payment in the local currency of the
country in which the loss is incurred, regardless of the functional currencies
of the parties to a particular transaction.
Refer to ASC 815-15-55-1 to 55-4 for implementation guidance on the
application of this scope exception to insurance contracts
As explained in ASC 815-15-15-11, an entity determines a counterparty’s
primary economic environment based on available information and
reasonable assumptions (i.e., representations need not be obtained from the
counterparty). An illustration regarding this determination is provided in
ASC 815-15-55-213 to 55-215. Refer to ASC 830-10-55-5 for guidance on
the economic factors that should be considered in determining an entity’s
functional currency.
The following expands on two of the key concepts in this embedded foreign
currency derivative scope exception.
Substantial party to a contract (ASC 815-15-15-12)
When determining who is a substantial party to the contract:

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Contract, transaction Conditions that must be met to be exempt from the guidance on
or feature embedded derivatives
• Consider all facts and circumstances related to the contract (e.g.,
whether a party has the knowledge, resources, and technology to fulfill
its contractual obligations without relying on related parties)
• Look through the legal form of the contract to analyze the substance of
the underlying relationships
The implementation guidance in ASC 815-15-55-84 to 55-95 provides useful
illustrations to determine if a party to a contract is substantial and if a highly
inflationary economy exists for a substantial party.
Routinely denominated in international commerce (ASC 815-15-15-14)
The application of the phrase routinely denominated in international
commerce should be based on the currency in which transactions for similar
products or services are routinely denominated in around the world rather
than in a local area. In other words, if transactions for a particular product or
service are routinely denominated in various currencies around the world,
the embedded foreign currency derivative scope exception in ASC 815-15-
15-10 does not apply to those transactions. This is illustrated through
Example 2 that begins at ASC 815-15-55-96.
Foreign currency caps and floors
ASC 815-15-15-15 to 15-19 should be considered when determining if the
scope exception applies to foreign currency caps and floors within a
nonfinancial contract.

3.1.3 Identifying potential embedded derivatives

An instrument that has terms that are not found in the most simple and basic instrument of its type may
contain one or more embedded derivatives. For example, a bond that is convertible by the holder and
callable by the issuer may contain embedded derivatives in the form of a redemption feature (i.e., a call
option) and a conversion option because an early redemption feature and a conversion option are not
part of a plain-vanilla bond. Because an embedded derivative is “implicit or explicit terms that affect some
or all the cash flows or the value of other exchanges required by a contract in a manner similar to a
derivative instrument”, it is helpful to focus on features that can alter the amount or timing of cash flows or
the manner or amount in which the contract can otherwise be settled (e.g., in shares rather than cash)
when determining what features within a contract may be embedded derivatives. The following table aids
in this determination by providing examples of terminology that may be found in a contract that could
indicate the existence of one or more embedded derivatives. The table is not intended to be all inclusive
and contracts may use similar, but not identical terms to describe the same features that may potentially
represent embedded derivatives.

Potential embedded
derivative Key terminology to watch for

Conversion options • Convert, convertible, upon conversion

(commonly found in
• Exchange, exchangeable
debt instruments and
preferred stock)

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Potential embedded
derivative Key terminology to watch for

Redemption features • Accelerate(d) repayment, prepay, repay

(commonly found in
• Call, callable, put, puttable
debt instruments and
preferred stock) • Upon the occurrence of certain contingent events (e.g., deemed
liquidation, liquidation, change in control), the instrument will be paid off,
redeemed
• Redeem, redeemable, upon redemption
• Repurchase
• Return

Interest rate • The rate will be adjusted, increased, decreased

features/indexation
• Ceiling(s), cap(s), floor(s), formula
• The rate will be determined by
• Index, indexed to, reference(d)

Credit indexation • Amount or timing of cash flows will be adjusted upon

- Bankruptcy
- Default
- Credit rating change

Foreign exchange • Exchange rate

indexation
• The mention of a specific currency that is not the currency of the parties
to the transaction
• Index, indexed to, reference(d)

Equity or earnings • Amount or timing of cash flows will be adjusted based on

indexation
- Equity index
- Earnings metrics (EBITDA, EPS, gain(s), loss(es), net income, profit,
revenue)
- Formula

Commodity price • Index, indexed to, reference(d) to a particular commodity price

indexation
• Ceiling(s), cap(s), floor(s), formula refencing a commodity index
• Price, pricing

Other • Cancel
• Choice, choose among, choose between

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Potential embedded
derivative Key terminology to watch for
• Condition, conditional, contingency, contingent
• Elect
• Entitle
• Exercise
• Extend, extension
• Option
• Right(s)

3.2 Derivative analysis of embedded features

The determination of which, if any, embedded derivative must be separately recognized as a derivative is
complex. Specifically, ASC 815-15-25-1 requires derivative recognition for embedded derivatives if all the
following three conditions are met:
1. 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.
2. The hybrid instrument is not remeasured at fair value under otherwise applicable U.S. GAAP.
3. A separate instrument with the same terms as the embedded derivative would be a derivative
instrument subject to the requirements of ASC 815 (i.e., it meets the definition of a derivative and
does not qualify for one of the scope exceptions outlined in ASC 815-10-15-13 or ASC 815-15-15).

A separate
Economic
The hybrid instrument with
characteristics
instrument is not the same terms
and risks of
remeasured at fair as the embedded
embedded Recognize feature
value under derivative would
derivative are not as derivative
otherwise be a derivate
clearly and
applicable U.S. instrument subject
closely related to
GAAP to ASC 815's
the host contract
requirements

An entity would account for an embedded feature separately as a derivative “if and only if” all the
preceding conditions are met. As such, if the determination is made that one condition is not met for a
particular embedded feature, the feature would not be accounted for as a derivative and there is no need
to consider if the other requirements are met.
An integral part of analyzing an embedded derivative to determine if it requires separate accounting is
determining the level of granularity to which the analysis applies.

Level of analysis
ASC 815 does not specify the level at which the features of a financial instrument or contract need to
be assessed to determine whether they represent embedded derivatives that require separate
accounting. Questions arise as to whether each embedded feature should be analyzed separately or
combined with similar features that may exist within the same instrument or contract. Entities may

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arrive at different conclusions on what features require separate accounting as a derivative depending
on the approach taken.
For example, if a convertible debt instrument can be converted into equity shares contingent upon the
occurrence of two separate events, for example, a change in control or an initial public offering (IPO),
the debt instrument could potentially be viewed as containing either:
• One conversion option (the combined approach) or
• Two separate conversion options (the separate approach)
Suppose in this example, there are different formulas for how the number of shares would be
determined upon conversion based on whether the event is a change in control or IPO and the
conversion feature upon a change in control meets all the requirements for the derivative scope
exception for contracts involving an entity’s own equity, but the conversion feature upon an IPO does
not qualify for this scope exception. In this case, if the entity applied the combined approach, it would
account for the entire conversion option separately as a derivative. However, if the entity applied the
separate approach, it would only account for the conversion feature upon an IPO as a derivative.
The level upon which the analysis should be applied is judgmental and many factors should be
considered, including:
• The party that can trigger the exercise of the feature (for options)
• Likeness of the underlyings
• How the settlement amounts are determined for each
• Situations that would trigger settlement
We believe that because of the judgment involved, a reporting entity should document its justification
for the approach taken and apply it consistently over time.
It should be noted that while a separate approach may be appropriate when analyzing embedded
features within a nonderivative host contract to determine which embedded features should be
accounted for as derivatives, it would not be appropriate to apply a separate approach to a
freestanding derivative instrument because the entire instrument is a derivative that is required to be
accounted for at fair value. To illustrate, if the instrument in question is a freestanding warrant
derivative that is exercisable upon a change in control or IPO (rather than being convertible debt
whereby the holder can convert upon a change in control or IPO) and either exercise feature (or for that
matter, any terms within the instrument) cause it to not qualify for the derivative scope exception for
contracts involving an entity’s own equity, the warrant in its entirety would be accounted for as a
derivative.

3.2.1 Clearly and closely related to the host contract

An entity considers whether the economic characteristics and risks of the embedded derivative are clearly
and closely related to the economic characteristics and risks of the host contract as part of the embedded
derivative analysis. If an entity determines that the economic characteristics and risks of the embedded
derivative are clearly and closely related to that of the host contract, the entity would not account for the
embedded derivative separately as a derivative. However, if the entity determines that 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 entity would account for the embedded derivative
separately as a derivative if the other two conditions in ASC 815-15-25-1 are met.
Determining the nature of the host contract is integral to assessing this condition. Sometimes, this
determination is straightforward (e.g., the host contract of a convertible bond would be a plain-vanilla-

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nonconvertible bond, and therefore a debt host contract). In other cases, identifying the nature of the host
contract can be challenging, particularly when the hybrid instrument is in the form of a share. It is not
uncommon for instruments like preferred stock to have both debt and equity-like characteristics, in which
case subjective conclusions need to be reached about whether the host contract is more like debt or
equity. (Refer to Section 3.2.1.1 of this chapter for guidance on analyzing instruments in the form of a
share).
To illustrate the significance of this determination, if an entity has determined that an instrument contains
an equity-like embedded derivative and the host contract is akin to equity, then the economic
characteristics and risks of the embedded derivative would be clearly and closely related to that of the
host contract and the embedded derivative would not be accounted for separately as a derivative.
Conversely, if the host contract is akin to debt, then the economic characteristics and risks of the equity-
like embedded derivative would be considered to be not clearly and closely related to that of the host
contract. In this later case, if the other two conditions in ASC 815-15-25-1 are met, the embedded
derivative would be accounted for as a derivative.
Although economic characteristics and risks sound technical, an entity can simply think of this as the
nature of the embedded derivative versus the nature of the host contract. The FASB has provided
application guidance and examples in ASC 815-15-25-16 to 25-51A to help an entity assess this
condition. (Refer also to Chapter 3 that follows for a more in-depth discussion of embedded derivative
considerations organized by type of host contract).
If the economic characteristics and risks of the embedded derivative are clearly and closely related to that
of the host contract, there is no need to perform the rest of the analysis as the embedded derivative
would not meet the requirement for separation as a derivative.
3.2.1.1 Hybrid instruments in the form of a share that have characteristics of both debt and
equity
Certain equity instruments, most commonly preferred stock, tend to have a mix of debt and equity-like
characteristics in which case an evaluation needs to be performed in accordance with the guidance that
begins at ASC 815-15-25-17A to determine if the host contract is more akin to debt or equity. This
determination is not based on the classification of the instrument in the statement of financial position, but
rather a subjective evaluation and weighting of all relevant terms and features of the instrument. It would
be rare for an instrument that is required to be classified as a liability to be considered more akin to
equity. The significance of this determination is that if the instrument is overall deemed to be more debt-
like, equity-like features such as a conversion option would have economic characteristics and risks that
are not clearly and closely related to the debt host contract. Conversely, if the instrument is overall
deemed to be more equity-like, debt-like features such as a redemption option would have economic
characteristics and risks that are not clearly and closely related to the equity host contract. It should also
be noted that the conclusion on whether a hybrid instrument that is in the form of a share is more equity-
like or debt-like can also impact conclusions reached on whether an embedded put, call or redemption
option is a derivative. This is because the net settlement characteristic of a derivative is deemed to exist
under ASC 815-15-15-107 for a put or call option embedded in a debt instrument. However, as noted in
ASC 815-15-15-109, 15-107 does not apply to hybrid instruments that do not contain a debt host contract.
As such, a put, call or redemption option that is embedded in an equity host contract would not be a
derivative unless the net settlement characteristic of a derivative otherwise exists (e.g., contractually or
because the underlying shares can be readily converted to cash).
The analysis of the nature of a hybrid instrument in the form of a share should be based on all stated and
implied substantive terms and features, with each term and feature evaluated to determine if it is more
debt-like or equity-like and weighted based on relevant facts and circumstances in existence at the date
of issuance. The template that follows is provided as a tool in evaluating and weighting features

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commonly associated with preferred stock to arrive at a conclusion on the nature of the host contract as
more debt-like or equity-like.

Insights on weighting certain

Factors to consider factors Analysis

Redemption rights (generally debt-like characteristic)

Is redemption mandatory or A mandatory redemption right

contingent? would be given more weight.
The weight placed on a
contingent redemption right
would be commensurate with
the likelihood of redemption
being triggered.

Who holds the redemption right? A redemption right held by an

investor would be given more
weight than if held by the
issuer.

Is the redemption right in the An in-the-money right would be

money or out of the money? given more weight.

Is a conversion option also Less weight would be placed

provided, and if so, how favorable on a redemption right if the
is this option in comparison to the conversion option was more
redemption right? favorable.

Are there legal restrictions and (or) Such restrictions and factors
solvency factors that would prohibit would reduce the weight placed
the issuer from redeeming the on the redemption right.
instrument?

Are there issuer-specific Such considerations would

considerations that make reduce the weight placed on
redemption unlikely (e.g., is the the redemption right.
issuer thinly capitalized or
unprofitable)?

Conversion rights (generally equity-like characteristic unless settlement will be in a variable

number of shares designed to result in a fixed amount of value)

Who holds the conversion right? A conversion right held by an

investor would be given more
weight than if held by the
issuer.

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Insights on weighting certain

Factors to consider factors Analysis

Is conversion mandatory? More weight would be placed

on a mandatory conversion
right.

Is the conversion right contingent? Less weight would be placed

on a contingent conversion
right, commensurate with the
likelihood of it not being
triggered.

Is the conversion right in the money An in-the-money conversion

or out of the money? right would be given more
weight.

If the instrument is also Less weight would be placed

redeemable, what is more likely to on the conversion right if
occur first, conversion or redemption was more likely to
redemption? occur first.

Rights upon liquidation

Is there a stated liquidation If so, the liquidation right is a

preference? debt-like characteristic.

Does the holder participate in the If so, the liquidation right is an

residual value of the entity? equity-like characteristic.

Voting rights (equity-like characteristic weighted commensurately with the level of influence the
rights provide)

Does the holder have voting rights

and if so, are they entitled to vote
on all or limited matters?

How much influence can the

holder’s class of stock exercise
based on its voting rights?

Dividend rights

Are the dividends mandatory or Mandatory dividends are a

discretionary? debt-like characteristic, while
discretionary dividends are an
equity-like characteristic.

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Insights on weighting certain

Factors to consider factors Analysis

Are the dividends stated or Stated dividends are a debt-like

participating? characteristic, while
participating dividends are an
equity-like characteristic.

Are the dividends cumulative or Cumulative dividends are a

noncumulative? debt-like characteristic, while
noncumulative dividends are an
equity-like characteristic

Protective covenants (debt-like characteristic weighted commensurately with the level of

protection the covenants provide)

Are there collateral requirements

akin to collateralized debt?

If the instrument contains a

redemption option held by the
investor (holder), is the issuer’s
performance upon redemption
guaranteed by the parent of the
issuer or otherwise?

Does the instrument provide the

holder with certain rights akin to
creditor rights (e.g., the ability to
force bankruptcy or a preference in
liquidation)?

Conclusion: Because the factors to consider and the most likely outcome of the instrument, conclude
as to the nature of the preferred stock host contract as more debt-like or equity-like and the weight
placed on the various features in reaching that conclusion.

If the conclusion is reached that the nature of the host contract is more debt-like, refer to the discussion
that follows on hybrid instruments with a debt host contract. If the conclusion is reached that the nature of
the host contract is more equity-like, refer to the discussion that follows on hybrid instruments with an
equity host contract
3.2.1.2 Hybrid instruments that are not in the form of a share
While there is extensive guidance beginning at ASC 815-15-25-17A to determine the nature of the host
contract for hybrid financial instruments that are in the form of a share, this guidance does not apply to
instruments that are not in the form of a share. The nature of the host contract for non-share instruments
is generally determined by excluding the potential embedded derivative(s) and focusing on the remaining
host contract. Therefore, the nature of the host contract for a hybrid instrument in the form of debt is
generally always debt even if the debt is convertible into equity.

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3.2.2 Instrument is not remeasured at fair value

The second condition that an entity must assess when determining whether it should account for an
embedded derivative separately as a derivative is whether the hybrid instrument would not otherwise be
measured at fair value with changes in fair value reported in earnings. That is because if the hybrid
instrument that contains the embedded derivative is accounted for at fair value with the changes in its fair
value recorded in earnings, the embedded derivative is essentially already receiving the accounting
treatment that would be required if it were accounted for separately as a derivative. This criterion
simplifies the accounting analysis for industries that account for substantially all investments at fair value
through earnings or the change in net assets, such as broker-dealers, investment companies, health and
welfare plans and postretirement plans.
Available-for-sale debt securities fail to meet this condition because the changes in fair value are
recorded in other comprehensive income, not earnings.

Fair value option

The complexity of reporting an embedded derivative separate from its host contract may be avoided by
electing to measure the entire hybrid instrument using the fair value option (FVO) provided by either
ASC 825-10 or ASC 815-15. Additional considerations apply when the FVO is applied to a liability
instrument because changes in fair value that are attributable to changes in the credit risk of that
instrument are reported through other comprehensive income instead of earnings.
Refer to ASC 815-15-25-4 to 25-6 and ASC 825-10 for further guidance on the application of the FVO
to hybrid financial instruments.
The FVO pursuant to ASC 825-10 has fewer restrictions on its use compared to the FVO pursuant to
ASC 815. For example, ASC 825-10 allows the FVO to be applied to qualifying financial instruments
regardless of whether an instrument contains an embedded derivative that requires separate
accounting.

3.2.3 Embedded component would be accounted for as a derivative

An entity does not account for an embedded derivative separately as a derivative unless a separate
instrument with the same terms as the embedded derivative meets the definition of a derivative and does
not qualify for one of the scope exceptions in ASC 815. Refer to Chapter 2 for the definition of a derivative
and the general scope exceptions in ASC 815 as well as Section 3.1.2 within this chapter for scope
exceptions specific to embedded derivatives.
ASC 815-15-25-1(c) states that the initial net investment for the hybrid instrument should not be
considered to be the initial net investment for the embedded derivative. The initial net investment of an
embedded derivative can be viewed in different ways. An example follows.

Determining the initial net investment for an embedded derivative

If a convertible bond is issued for $10 million, the $10 million is the initial net investment for the hybrid
instrument and not the initial net investment for the embedded conversion option. Hypothetically, the
initial net investment for the conversion option would be the amount one would pay to obtain the
conversion option (i.e., its fair value at the time of the transaction). Generally, an investor economically
pays for the conversion option by receiving a lower interest rate on a convertible bond than it would
otherwise find acceptable for the same bond absent the conversion option. Continuing along with the
convertible bond example, let us assume that the bond can convert into one million shares ($10 per
share conversion price) and each share was worth $12 at the time the bond was issued. In this case,
the fair value of the conversion option (its initial net investment) would be less by more than a nominal
amount than the initial net investment that would need to be exchanged to acquire the underlying

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shares ($12 each). In other words, the value of the conversion option would be significantly less than
the value of the shares because there is a $10 per share cost to exercise that conversion option. We
have observed that the initial net investment characteristic of a derivative is often met for an embedded
feature. Refer to Section 2.2.1.3 of Chapter 2 for further discussion on the initial net investment
characteristic of the definition of a derivative.

Although an entity generally performs the analysis in ASC 815-15-25-1(c) as if the embedded derivative
was a freestanding instrument, there is one exception to this approach. As explained in ASC 815-15-25-
14, the guidance in ASC 480-10-25-4 to 25-14 for distinguishing liabilities from equity is not considered
when determining whether the embedded derivative should be equity classified for purposes of applying
the own equity scope exception in ASC 815-10-15-74(a). The reason for this is that ASC 480 only applies
to freestanding instruments.
3.3 Application of the embedded derivative guidance to various types of host contracts
The rest of this chapter will focus on how the guidance on embedded derivatives applies to the following
hybrid instruments:
• Hybrid instruments with a debt host contract
• Hybrid instruments with an equity host contract
• Hybrid instruments with a lease host contract
• Hybrid instruments with an insurance host contract
• Hybrid instruments with an executory host contract
3.3.1 Hybrid instruments with a debt host contract
It is common for debt instruments or host contracts to have embedded features that may require separate
recognition as derivatives, including:
• Conversion options
• Early redemption features (such as put and call options that can accelerate payoff)
• Additional payments if a contingent event such as a change in control occurs
• Interest that is indexed to something other than interest rates
The focus when determining if there are features within a debt host contract that may require separate
recognition as a derivative should be on features that can alter the amount or timing of cash flows or the
way the contract can be settled (e.g., in shares rather than cash).
Pursuant to ASC 815-15-25-25, it would be inappropriate for an entity to express the characteristics of a
debt host contract in a way that would result in it identifying an embedded derivative that is not clearly
present in the hybrid instrument.
For example, suppose an entity issues fixed-rate debt that is convertible into equity and separately enters
into an interest rate swap, the economic effects of which are to essentially convert the fixed-rate on the
debt into a variable rate. It would be appropriate to deconstruct that bond into a fixed-rate debt host
contract and an embedded equity conversion feature, but it would not be appropriate to view that bond as
a variable-rate debt host contract because the variable rate is a characteristic that is not present in the
host contract.
3.3.1.1 Interest rate features, including leverage factors
A hybrid instrument with a debt host contract may contain embedded derivatives that affect the interest
rate or otherwise impact the interest payments on the instrument. Although interest is central to a debt

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host contract, not every embedded interest rate derivative will have economic characteristics and risks
that are clearly and closely related to its debt host contract. For example, a debt instrument may contain
an embedded interest derivative that leverages the interest rate on the instrument to such a great degree
that the economic characteristics and risks of the embedded interest derivative are not clearly and closely
related to the host contract.
Pursuant to ASC 815-15-25-26, an embedded derivative in which the only underlying is an interest rate or
interest rate index (e.g., an interest rate cap, floor, or collar) that alters the net interest payments that
otherwise would be paid or received on an interest-bearing debt host contract is considered to be clearly
and closely related to the host contract unless either of the following conditions exists:
• There is a possible situation (no matter how remote) in which the creditor or investor could be forced
by the terms of the instrument to accept settlement in such a way that it would not recover
substantially all its initial recorded investment (ASC 815-15-25-26(a)). In making this determination,
an entity should consider the undiscounted net cash flows that the creditor or investor would receive if
the potential embedded derivative was triggered in comparison to its initial recorded investment. In
practice, substantially all has generally been interpreted to mean at least 90% of the initial recorded
investment will be recovered. An example of when this condition would exist includes a situation
whereby debt is issued at a premium greater than 10% and gives the debtor the option of prepaying
at par. Conversely, this condition would not exist if the instrument could be put by the investor or
creditor because it only applies when the issuer has the contractual right to demand settlement in this
manner. Refer to example 10 beginning at ASC 815-15-55-128 for further guidance.
• There is a possible future interest rate scenario under which the embedded derivative could at least
double the creditor or investor’s initial rate of return on the debt host contract and result in a rate of
return that would be at least twice the then-current market rate of return (based on the possible future
interest rate scenario) for a contract with the same terms involving a debtor with similar credit quality
to the actual debtor’s credit quality at the inception of the contract (ASC 815-15-25-26(b)). This
condition does not apply if the right to accelerate the payment of the debt can only be exercised by
the debtor. This condition is referred to as the double-double test.
There are some important considerations to keep in mind when applying this guidance in ASC 815-15-25-
26 including:
• This guidance does not apply if the embedded derivative has an underlying that is not an interest rate
or interest rate index. Examples include embedded derivatives that tie interest payments to a stock or
commodity price or index. Such embedded derivatives do not have economic characteristics and
risks that are clearly and closely related to a debt host contract.
• While this guidance generally applies to call or put options or other embedded features that can
accelerate the repayment of principal, it does not apply if the acceleration is contingent on the
occurrence or non-occurrence of a certain event because such a contingency is a non-interest rate
underlying. (ASC 815-15-25-42, which is discussed in Section 3.3.1.5 of this chapter is applicable to
contingent features that can accelerate repayment). The analysis for determining whether either of
the two conditions exists should be performed after allocating the issuance proceeds to freestanding
financial instruments that may have been issued together in the same transaction, such as warrants
and debt.
• As noted in ASC 815-15-25-27, while the focus of this guidance is on the investor’s return and
recovery of investment, the existence of either one or both of the two conditions would result in a
conclusion for both parties that the embedded derivative is not clearly and closely related to the host
contract. Because of the fact that this analysis should be performed when the instrument is issued or
acquired by the reporting entity, an entity that acquires the instrument after its initial issuance date
could reach a different conclusion than the issuer did because they are applying the guidance at
different points in time and potentially different circumstances (e.g., the issuer may have issued the

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instrument at face however a subsequent acquirer may have paid a premium or discount on the
secondary market).
• Interest-only and principal-only strips may qualify for the derivative scope exception described in
ASC 815-10-15-72 to 15-73
• ASC 815-15-25-33 through 25-36 addresses the application of this guidance to derivatives that are
embedded in securitized interests in prepayable financial assets
The following excerpt from ASC 815-15-55-25 illustrates application of the requirements in ASC 815-15-
25-26(b) to various instruments.

Paragraph
815-15-25-26(b)
Applicable to
the Embedded
Instrument Call Option? Comments

1. An unsecured commercial loan that No. The commercial loan is prepayable only at
includes a prepayment option that the option of the borrower.
permits the loan to be prepaid by the
borrower at a fixed amount at any
time at a specified premium over the
initial principal amount of the loan.

2. A fixed-rate debt instrument issued No. The fixed-rate debt instrument is callable at
at a discount that is callable at par par value only by the issuer.
value at any time during its 10-year
term.

3. A fixed-rate 10-year bond that No. The fixed-rate 10-year bond is callable only
contains a call option that permits the at the option of the issuer.
issuer to prepay the bond at any time
after issuance by paying the investor
an amount equal to all the future
contractual cash flows discounted at
the then-current Treasury rate plus 45
basis points. The spread over the
Treasury rate for the borrower at the
issuance of the bond was 300 basis
points.

4. A 5-year debt instrument issued at No. The instrument is callable only by the
par that has a quarterly coupon equal issuer, so the embedded call option feature
to 15 percent minus 3 times 3-month will not be subject to the conditions in
LIBOR and that includes a call paragraph 815-15-25-26(b). However, the
provision that allows the issuer to call conditions in that paragraph are still
the debt at any time at a specified applicable to the levered index feature of
premium over par. the debt.

5. A fixed rate debt instrument is No. The instrument is callable only by the
issued at par and is callable at any issuer, so the embedded call option feature

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Paragraph
815-15-25-26(b)
Applicable to
the Embedded
Instrument Call Option? Comments
time during its 10-year term. If the will not be subject to the conditions in
debt is called, the investor receives paragraph 815-15-25-26(b). However, the
the greater of the par value of the embedded call option is not considered
debt or the market value of 100,000 clearly and closely related to the debt host
shares of XYZ common stock (an contract because the payoff is based on an
unrelated entity). equity price.

6. A mortgage-backed security is Not applicable Although the related mortgage loans are
issued, whereby cash flows (see comments). prepayable, and thus each contain a
associated with principal payments separate embedded call option, the
(including full or partial prepayments mortgage-backed security itself does not
and related penalties) received on the contain an embedded call option. While the
related mortgage loans are passed mortgage-backed security investor is
through to the mortgage-backed subject to prepayment risk, the mortgage-
security investors. backed security issuer has the obligation
(not the option) to pass through cash flows
from the related mortgage loans to the
mortgage-backed security investors.
Therefore, mortgage-backed securities are
not within the scope of this guidance.
Paragraphs 815-15-25-33 through 25-36
address the application of paragraph 815-
15-25-26(b) to securitized interests in
prepayable financial assets.

3.3.1.1.1 Doubling the initial and market rate of return

A debt instrument may contain an embedded interest derivative that positively leverages the interest rate
of the instrument to such a great degree that the return on the debt instrument is no longer indicative of a
debt instrument. ASC 815-15-25-26(b) provides guidance on how to assess if an interest rate leveraging
feature is clearly and closely related to its debt host contract. This assessment is commonly called the
double-double test.
The following table explains how to address certain items when performing the double-double test.

Commentary

Initial rate of return An entity should use the IRR on the debt host contract (i.e., not the hybrid
instrument) without the embedded derivative in the double-double test. The
initial rate of return on the debt host contract may differ from the stated yield
of the hybrid instrument for this reason as well as other factors such as the
debt being issued or acquired at a premium or discount. An entity should
perform this analysis regardless of the probability of the event (that would
leverage the interest) occurring.

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Commentary

Transactions with When considering transactions with multiple elements (e.g., debt issued with
multiple elements warrants), an entity should perform the double-double test after the proceeds
have been allocated to the separate transactions.

Interest rate provisions within a debt host contract that may appear on the surface to be rather benign can
meet the double-double test outlined in ASC 815-15-25-26(b) and therefore result in an embedded
derivative that should be accounted for separately. Something to watch for is whether there is an
inconsistency between how the variable interest rate is determined and how frequently the interest rate
resets. Consider the following example of a financial instrument that pays an interest rate that is based on
a rolling average of a variable rate, including the following assumptions:
• Interest is based on the 12-month rolling average of one-month LIBOR
• Interest rate resets monthly
• Interest is paid monthly
• One-month LIBOR is 1% at the initial recognition of the instrument
• The 12-month rolling average of one-month LIBOR interest rates is 1.2% at the initial recognition of
the instrument
Based on these assumptions, an entity would view this instrument as having a debt host contract that
pays interest based on one-month LIBOR that resets every month and an embedded derivative that
adjusts the interest rate from one-month LIBOR to the 12-month rolling average of one-month LIBOR.
Continuing our example, consider the following scenario that while it may be remote, is possible of
occurring:
• One-month LIBOR moves up to 4% and remains at 4% for 11 months
• In the twelfth month, one-month LIBOR drops to 1.5%
After LIBOR was 1.5% for one month, the interest rate on the instrument would be approximately 3.79%
((4% x 11) + 1.5%)/12), which would be more than twice the initial rate of return of the host contract of 1%
while also being more than twice the then current one-month LIBOR market rate of 1.5%. In this case, the
embedded derivative that adjusts the interest rate from one-month LIBOR to the 12-month rolling average
of one-month LIBOR would not be considered clearly and closely related to the host contract. As a result,
the embedded derivative would be accounted for separately as a derivative unless the hybrid instrument
is accounted for in its entirety at fair value through earnings.
Example 13 that begins at ASC 815-15-55-165 includes various cases that illustrate the application of the
embedded derivative guidance to debt host contracts.
See the table in Section 3.3.1.1 of this chapter that comes from ASC 815-15-55-25 and provides
application of the guidance in ASC 815-15-25-37 through 25-39 to specific debt instruments.
3.3.1.1.2 Interest rate reset features related to the elimination of LIBOR

The LIBOR, which is referenced in approximately $350 trillion of contracts, is expected to be eliminated
by June 30, 2023. In the U.S., the Alternative Reference Rates Committee (ARRC) convened by the
Federal Reserve Board has recommended the Secured Overnight Financing Rate (SOFR) as the
preferred alternative to LIBOR. The replacement of LIBOR with an alternative rate will have broad

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reaching effects on entities that have assets, debt instruments, interest rate swap agreements or other
contracts that reference LIBOR.
At a conference in December 2020, the SEC staff discussed a fact pattern related to evaluating
whether certain SOFR-based interest rate reset features are embedded derivatives that require
separate accounting 1. The fact pattern discussed the following interest rate reset conventions:
• Term SOFR
• Compounded SOFR in-arrears
• Compounded SOFR in-advance
• Average SOFR in-advance
In this fact pattern, an entity needed to assess whether the above features should be considered terms
of the debt host contract. If the entity cannot conclude that these features are terms of the debt host
contract, they would be considered embedded derivatives and require further analysis to determine if
separate accounting as a derivative is required because for example, the double-double test discussed
at Section 3.3.1.1 of this chapter is met. However, the entity determined that these features should be
considered terms of the debt host contract based on the following:
• The SOFR interest-rate features were meant to provide a “market-based solution” to LIBOR
elimination.
• The purpose of the features is not to leverage the investor’s returns.
• Counterparties were not looking to add complex basis swaps.
• Consumer protection laws require certain of these reset features for specific lending products.
The SEC staff did not object to the entity’s view that these four SOFR-based interest rate features are
terms of the host contract rather than embedded derivatives that could potentially require separate
accounting.

3.3.1.1.3 Interest rate caps and floors

Pursuant to ASC 815-15-25-32, interest rate caps and floors (including collars, which are combinations of
caps and floors) are considered to be clearly and closely related to their debt host contract, unless either
of the conditions in ASC 815-15-25-26 are met. Those conditions are typically not met such that
embedded interest rate caps or floors are generally not accounted for as a derivative.
3.3.1.1.4 Inflation-linked bonds
An inflation-linked bond is a debt instrument that pays an interest rate on an amount of principal that is
adjusted for the rate of inflation as measured by an inflation index. Treasury Inflation-Protected Securities
and inflation-indexed savings bonds are tied to the value of the Consumer Price Index (CPI). Generally,
the outstanding principal and therefore interest paid on an inflation-linked bond rises with inflation. As a
result, inflation-linked bonds can mitigate the impact of inflation on the investors of these bonds.
As indicated in ASC 815-15-25-50, the interest rate and the inflation rate in the economic environment for
the currency in which a debt instrument is denominated are considered clearly and closely related. Thus,
an entity would not separate an inflation-related embedded derivative from its debt host contract unless
the derivative creates significant leverage. A leveraged inflation feature would not be considered clearly

1 A script of the remarks is available at https://www.sec.gov/news/speech/pearce-remarks-aicpa-2020.

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and closely related to a debt host contract and would need to be separately recognized as a derivative if it
has all the characteristics of a derivative and the debt is not accounted for at fair value through earnings
in its entirety. An example of a leveraged inflation feature is a bond where the principal on the bond is
adjusted by a multiple of CPI, rather that CPI by itself.
3.3.1.1.5 Default interest
Many debt instruments contain a feature that requires the issuer or borrower to pay additional interest to
the investor or holder based on the occurrence of certain credit events (e.g., covenant violation, failure to
make a payment when due or other events of default).
ASC 815-15-25-46 provides the following guidance on embedded derivatives that adjust the interest rate
on an instrument based on the issuer’s or borrower’s creditworthiness:
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:
a. Default (such as violation of a credit-risk-related covenant)
b. A change in the debtor’s published credit rating
c. A change in the debtor’s creditworthiness indicated by a change in its spread over U.S. Treasury
bonds
The preceding guidance illustrates default by mentioning a credit-risk-related covenant violation. It is not
uncommon for default provisions that adjust the interest rate on an instrument to encompass
circumstances such as a change in control of the entity that are not directly tied to the debtor’s credit risk,
in which case, the feature may require separate accounting as a derivative if the requirements of
ASC 815-15-25-1 are otherwise met.
Certain debt instruments that are convertible into the issuer’s common shares express the trigger for
contingent interest in terms of the market price or fair market value of the instrument. Although changes in
interest rates and credit risk affect the market price or fair market value of a hybrid convertible debt
instrument, the issuer’s common stock price is often the prevalent underlying. Therefore, such contingent
interest provisions likely would be considered not clearly and closely related to a debt host contract.
As explained in ASC 815-15-25-47, a debt instrument that incorporates a credit risk of a party other than
the issuer of the instrument (e.g., payments required by the debt instrument can be impacted by an event
of default or a change in creditworthiness of an entity other than the issuer), contains a potential
embedded credit derivative that could require separate derivative accounting if the requirements of
ASC 815-15-25-1 are met. In this case, the host contract and potential embedded derivative both have
the economic characteristics and risks of debt. However, the host contract has the economic
characteristics and risks of debt issued by the issuer, but the embedded derivative has the economic
characteristics and risks of debt issued by another party. Therefore, the host contact and potential
embedded derivative are not clearly and closely related. This guidance does affect the accounting for
nonrecourse debt whereby if the debtor does not make the payments due under the instrument, the
creditor’s recourse is limited to the collateral pledged under the debt instrument.
3.3.1.2 Beneficial interests in securitizations
In a securitization transaction, a transferor transfers financial assets into another legal entity that creates
ownership interests backed by the transferred assets and issues those interests to third-party investors.
The process of creating these asset-backed interests is referred to as securitization and the interests
themselves are commonly referred to as beneficial interests.

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Beneficial interests are defined in the ASC Master Glossary as rights to receive all or portions of specified
cash inflows received by a trust or other entity, including, but not limited to the following:
a. Senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or
paid-through
b. Premiums due to guarantors
c. Commercial paper obligations
d. Residual interests, whether in the form of debt or equity.
Examples of beneficial interests include mortgage-backed securities, asset-backed securities,
collateralized debt obligations, collateralized loan obligations, I/Os and P/Os.
Beneficial interests that can contractually be prepaid or otherwise settled in such a way that the beneficial
interest holder would not recover substantially all its recorded investment would be accounted for as
available-for-sale or trading securities under ASC 320. If the beneficial interest is not accounted for at fair
value through earnings or does not meet the scope exception for certain IOs and POs (see ASC 815-10-
15-72 to 15-73 and Case B that begins at ASC 815-15-55-153), the holder should analyze the beneficial
interest to determine if it requires derivative recognition in its entirety or if it contains any embedded
derivatives that are required to be accounted for separately. As discussed in ASC 815-15-25-12, an entity
should base this determination on the contractual terms of the beneficial interest. This requires the entity
to understand the nature and amount of assets, liabilities and other financial instruments (e.g., options,
guarantees) involved in the entire securitization transaction. In addition, the entity must understand the
payment priority and payoff structure of the beneficial interest.
As part of the determination of whether the beneficial interest is a derivative in its entirety or contains an
embedded derivative, an entity will have to assess whether the initial net investment characteristic of a
derivative is present. That characteristic is present when the initial net investment “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.” Refer to Section 2.2.1.3 of this chapter for more discussion on the Initial net investment
characteristic of a derivative.
Various examples of the application of the embedded derivative analysis to beneficial interests and
securitization structures are provided in ASC 815-15-55-222 to 55-226D. The following is a summary of
select features that generally warrant further assessment to determine whether derivative recognition is
necessary.
• Prepayment features that are embedded in the financial assets that underly the beneficial interests
• Put or call options embedded in the beneficial interest
• Clean-up call held by the servicer or options of one of the parties to the transfer to purchase financial
assets from the securitization vehicle (including removal of accounts provisions aka ROAPs)
• Credit default swaps, interest rate swaps, cross-currency swaps and other derivatives that an entity
enters into as part of the securitization structure, particularly when the notional amount of the
derivative does not match the securitized assets or may not match the securitized assets as
prepayments occur (refer to ASC 815-15-55-144, ASC 815-15-55-223 and ASC 815-15-55-226B
through 55-226D)
• Any transfer of credit risk that does not solely arise from subordination of one financial instrument to
another (refer to ASC 815-15-15-9)
• Payments are denominated in a different currency than the underlying assets (refer to Case V that
begins at ASC 815-15-55-222)

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• Interest rate features that are inconsistent with the underlying assets (e.g., the underlying assets and
the beneficial interest are indexed to different variable rate indices or the underlying assets have a
fixed rate and the beneficial interest has a variable rate). Refer to Case X that begins at ASC 815-15-
55-224
• A feature that may require the beneficial interest holder to make future payments rather than just
receive reduced cash inflows, regardless of how unlikely it is that the holder will be required to make
payments (refer to ASC 815-15-25-51A and ASC 815-15-55-226B)
• Features that could otherwise result in the holder not recovering substantially all its initial recorded
investment or meeting the double-double test described at Section 3.3.1.1 of this chapter
Refer to ASC 815-15-25-33 to 25-36, ASC 815-15-25-51A and Example 11 that begins at ASC 815-15-
55-137 for further guidance on the embedded derivative analysis associated with beneficial interests and
securitized financial assets.
A common structure that typically contains an embedded credit derivative is a collateralized debt
obligation aka a CDO. A CDO is a structured financial product that pools together cash flow-generating
assets that are in the form of debt obligations and repackages them into various tranches of investments
to be sold to investors. The debt obligations serve as the collateral for the investment tranches. That is,
the cash flows received from the debt obligations are used to fund the payments to be made on the
investment tranches. Each tranche has a different priority in terms of the cash flows from the debt
obligations. As a result, each tranche has a different risk and reward profile. In addition, the various
tranches may have different principal balances, coupon rates, prepayment risk, and maturity dates. These
CDOs are also referred to as cash collateralized CDOs because the tranches sold to investors are
backed by actual debt obligations (i.e., cash instruments).
ASC 815-15-15-9 indicates the transfer of credit risk that is only in the form of subordination of one
financial instrument to another thereby redistributing credit risk does not create an embedded derivative
that is accounted for separately. This element of a CDO does not result in an embedded derivative that
should be accounted for separately. However, an entity should analyze the specific facts and
circumstances regarding a securitization structure to determine whether it contains an embedded credit
derivative that does require separate accounting. Other embedded credit derivatives (e.g., those related
to credit default swaps on a referenced credit) may require separate accounting. In addition, an entity
should assess whether such structures contain other types of embedded derivatives (e.g., embedded
interest rate and (or) prepayment derivatives).
In contrast to the previously discussed cash collateralized instrument, synthetic instruments also exist in
the marketplace. Rather than being backed by cash instruments, synthetic instruments are backed by
derivative instruments to replicate the effect of investing in cash instruments. For example, the effect of
investing in a 30-year debt obligation issued by ABC Corp. can be replicated by investing in a 30-year
U.S. Treasury obligation and simultaneously entering into a credit default swap that references the ABC
Corp. debt obligation. A synthetic CDO of multiple obligors could be created by investing in a U.S.
Treasury obligation and entering into an array of credit default swaps. Given the exception in ASC 815-
15-15-9 only applies to the transfer of credit risk in the form of subordination of one financial instrument to
another, the credit default swaps would require derivative recognition.
3.3.1.3 Commodity indexed payments
A debt instrument or loan may contain an embedded derivative that causes the loan payments to be
impacted by the price of a commodity. For example, consider a loan that a bank makes to a gas
producer. Imagine that the bank and the gas producer agree that the gas producer will pay a greater rate
of interest than it otherwise would when gas prices are high; and in exchange for this, the gas producer
will pay a lesser rate of interest than it otherwise would when gas prices are low. Because the interest
rate in this loan agreement is tied to the price of gas, the loan contains an embedded gas price derivative.

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This hybrid instrument could be viewed as being comprised of a debt host contract that pays a rate of
interest that is typical for the particular borrower and an embedded gas indexation derivative. The
economic characteristics and risks of the host contract are that of debt and the economic characteristics
and risks of the embedded derivative are that of a commodity. Therefore, the embedded derivative is not
clearly and closely related to the host contract. As a result, assuming the hybrid instrument is not
measured at fair value with changes in fair value recorded in earnings, the embedded derivative would be
accounted for separately.
3.3.1.4 Loans that enable the lender or investor to participate in the appreciation of the financed
property, expected residual profit or a share of net earnings or operating cash flows
The following excerpts from ASC 815-15-55 illustrate the application of the derivative scope exceptions
for non-exchange traded contracts that are discussed in Section 2.3.5 of Chapter 2 to certain derivatives
that may be embedded in debt host contracts.

Example 3.3.1: Participating mortgage (from ASC 815-15-55-8 to 55-9)

Under an example participating mortgage, the investor receives a below-market interest rate and is
entitled to participate in the appreciation in the fair value of the project that is financed by the mortgage
upon sale of the project, at a deemed sale date, or at the maturity or refinancing of the loan. The
mortgagor must continue to own the project over the term of the mortgage.
The instrument has a provision that entitles the investor to participate in the appreciation of the
referenced real estate (the project). However, a separate contract with the same terms would be
excluded by the exception in paragraph 815-10-15-59(b) because settlement is based on the value of
a nonfinancial asset of one of the parties that is not readily convertible to cash. (This Subtopic does
not modify the guidance in Subtopic 470-30).

Example 3.3.2: Equity Kicker Feature (from ASC 815-15-55-10 to 55-11)

Paragraph 310-10-05-9 explains that loans granted to acquire operating properties sometimes grant
the lender a right to participate in expected residual profit from the sale or refinancing of the property.
An equity kicker (or expected residual profit) would typically not be separated from the host contract
and accounted for as an embedded derivative because paragraph 815-15-25-1(c) exempts a hybrid
contract from bifurcation if a separate instrument with the same terms as the embedded equity kicker
is not a derivative instrument subject to the requirements of this Subtopic. Under paragraph 815-10-
15-59(b), an embedded equity kicker would typically not be subject to the requirements of this
Subtopic because the separate instrument with the same terms is not exchange traded and is indexed
to nonfinancial assets that are not readily convertible to cash. Similarly, if an equity kicker is based on
a share in net earnings or operating cash flows, it would also typically qualify for the scope exception
in paragraph 815-10-15-59(d). If the embedded derivative does not need to be accounted for
separately under this Subtopic, the Acquisition, Development, and Construction Arrangements
Subsections of Subtopic 310-10 shall be applied.
A loan with an equity kicker of more than 50 percent of net earnings that is considered to be an
investment in real estate under the Acquisition, Development, and Construction Arrangements
Subsections of Subtopic 310-10 would not be analyzed under this Subtopic as a host loan contract
and an embedded equity kicker derivative.

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3.3.1.5 Redemption options and other features that can accelerate payoff
Redemption options can be thought of as put options or call options.

Option type Description

Put Allows the investor to demand repayment prior to its maturity

Call Allows the issuer or borrower to pay off the debt or loan prior to its
scheduled repayment terms

Pursuant to ASC 815-15-25-41, a put or call option that does not accelerate debt repayment, but rather
requires cash settlement in an amount equal to the price of the option on the date of exercise would be
considered not clearly and closely related to the debt host contract. As a result, such a put or call option
would be accounted for separately as a derivative if it met all the characteristics of a derivative.
A put or call option that accelerates the repayment of principal on a debt instrument requires further
analysis to determine whether the option is clearly and closely related to its debt host contract.
The guidance beginning at ASC 815-15-25-42 outlines the following four-step decision sequence that
should be followed in determining whether an option that can accelerate the settlement of a debt
instrument is clearly and closely related to the debt host contract.

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Step 1: Is the amount paid

? upon settlement (i.e.,

payoff) adjusted based on
changes in an index?

Yes

Step 2: Is the payoff

?
Embedded feature is not
No indexed to an underlying
Yes clearly and closely related to
other than interest rates or
the debt host contract.
credit risk?

No

?
Step 3: Does the debt Further analyze the contract
involve a substantial No under ASC 815-15-25-26, if
premium or discount? applicable.

Yes

Step 4: Does a contingently

?
exercisable call (put) option
accelerate the repayment of No
the contractual principal
amount?

Yes

Call (put) option is not clearly and

closely related to the debt
instrument.

This decision sequence results in a conclusion that put and call options are not clearly and closely related
to a debt host contract under any of the following circumstances:
• Rather than being the repayment of principal at par, the payoff amount is indexed to something other
than interest rates or credit risk.
• The debt involves a substantial premium or discount and the option is contingently exercisable.
• One of the two conditions outlined in ASC 815-15-25-26 are met, if applicable. (Refer to Section
3.3.1.1 of this chapter).
An example of the type of put or call option that we have observed most frequently in practice that is not
clearly and closely related to the debt host contract is a feature that will result in repayment of the debt at
a significant premium upon the occurrence of a contingent event, such as a change in control. When

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considering Steps 1 and 2 of the decision sequence, we believe repayments that are based on either a
fixed premium to par or a premium that changes due to the passage of time would not be considered
indexed to something other than interest rates or credit risk.
In evaluating the significance of a premium or discount in Step 3, premiums or discounts of 10% or more
are generally viewed as substantial. However, consideration should be given to the specific facts and
circumstances. Generally, a put or call option would not be considered to involve a substantial discount or
premium if it required a debt instrument to be paid off at its accreted value. Additionally, we believe that
when determining if the debt involves a substantial premium or discount, an entity should consider not
only the relationship of the par amount to the issuance proceeds attributable to the debt, but also the
relationship of the payoff amount to the issuance proceeds attributable to the debt. As such, even when
debt is issued at par, but a portion of the proceeds is allocated to other freestanding instruments (such as
warrants), the debt could be deemed to involve a substantial discount. Generally, it would not be
appropriate to consider discounts created by separately recognizing a conversion option associated with
the debt given that typically the holder would not benefit from the conversion option if the instrument is
redeemed. However, it may be necessary to consider premiums or discounts created from bifurcating
other embedded derivatives from the debt that could result in payments that are incremental to the
redemption feature and can be triggered prior to or on the redemption date. Additionally, while fees paid
to the creditor can create a discount that would be considered in this analysis, discounts related to
issuance costs paid to third parties would be ignored in this analysis.
The guidance in ASC 815-15-25-26 discussed at Section 3.3.1.1 of this chapter should be considered
before concluding noncontingent puts and calls and other features in a debt instrument that can alter the
interest payments are clearly and closely related to a debt host contract if the only underlying in the
potential derivative is an interest rate or interest rate index. If exercise of a put or call option is contingent
on the occurrence of a certain event, such as a change in control, this would constitute a non-interest rate
underlying and, as such, ASC 815-15-25-26 would not be relevant to the analysis for that option. The
following table reproduced from ASC 815-15-55-13 demonstrates the application of the four-step decision
sequence in ASC 815-15-25-42 for determining whether call options and put options that can accelerate
the settlement of a debt instrument should be considered to be clearly and closely related to the debt host
contract under the criterion in ASC 815-15-25-1(a).

Indexed Substantial
Payoff? Discount or Contingently Embedded Option
(Steps 1 Premium? Exercisable? Clearly and Closely
Instrument and 2) (Step 3) (Step 4) Related?

1. Debt that is issued at No. Yes. No. The embedded call

a substantial discount option is clearly and
is callable at any time closely related to the debt
during its 10-year term. host contract because the
If the debt is called, the payoff is not indexed, and
investor receives the the call option is not
par value of the debt contingently exercisable.
plus any unpaid and
accrued interest.

2. Debt that is issued at Yes, based N/A. N/A. Analysis The embedded call
par is callable at any on an equity Analysis not not required. option is not clearly and
time during its term. If price. required. closely related to the debt
the debt is called, the host contract because the
investor receives the

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Indexed Substantial
Payoff? Discount or Contingently Embedded Option
(Steps 1 Premium? Exercisable? Clearly and Closely
Instrument and 2) (Step 3) (Step 4) Related?
greater of the par value payoff is indexed to an
of the debt or the equity price.
market value of
100,000 shares of XYZ
common stock (an
unrelated entity)?

3. Debt that is issued at Yes, based N/A. N/A. Analysis The embedded put option
par is puttable if the on an equity Analysis not not required. is not clearly and closely
S&P 500 Index index (S&P required. related to the debt host
increases by at least 20 500). contract because the
percent. If the debt is payoff is indexed to an
put, the investor equity price.
receives the par
amount of the debt
adjusted for the
percentage increase in
the S&P 500.

4. Debt that is issued at No. Yes. Yes, contingent The put option is not
a substantial discount on a movement clearly and closely
is puttable at par if of LIBOR of at related to the debt host
LIBOR either increases least 150 basis contract because the
or decreases by 150 points. debt was issued at a
basis points. substantial discount and
the put option is
contingently exercisable.

5. Debt that is issued at No. Yes. Yes, contingent The put option is not
a substantial discount on a change in clearly and closely
is puttable at par in the control. related to the debt host
event of a change in contract because the
control. debt was issued at a
substantial discount and
the put option is
contingently exercisable.

6. Zero coupon debt is No. Yes. Yes, contingent The call option is clearly
issued at a substantial on a change in and closely related to the
discount and is callable control, but debt host contract.
in the event of a since the debt is Although the debt was
change in control. If the callable at the issued at a substantial
debt is called, the accreted value, discount and the call
issuer pays the the call option option is contingently
accreted value does not exercisable, the call
(calculated per accelerate the option does not

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Indexed Substantial
Payoff? Discount or Contingently Embedded Option
(Steps 1 Premium? Exercisable? Clearly and Closely
Instrument and 2) (Step 3) (Step 4) Related?
amortization table repayment of accelerate the repayment
based on the effective principal. of principal because the
interest rate method). debt is callable at the
accreted value.

7. Debt that is issued at No. No. N/A. Analysis The embedded put option
par is puttable at par in not required. is clearly and closely
the event that the related to the debt host
issuer has an initial contract because the
public offering. debt was issued at par
(not at a substantial
discount) and is puttable
at par. Paragraph 815-
15-25-26 does not apply.

8. Debt that is issued at Yes, based N/A. N/A. Analysis The embedded put option
par is puttable if the on an equity Analysis not not required. is not clearly and closely
price of the common price (price required. related to the debt host
stock of Entity XYZ (an of Entity contract because the
entity unrelated to the XYZ’s payoff is indexed to an
issuer or investor) common equity price.
changes by 20 percent. stock).
If the debt is put, the
investor will be repaid
based on the value of
Entity XYZ’s common
stock.

9. Debt is issued at a Yes, based N/A. N/A. Analysis The embedded put option
slight discount and is on an equity Analysis not not required. is not clearly and closely
puttable if interest rates index (S&P required. related to the debt host
move 200 basis points. 500). contract because the
If the debt is put, the payoff is based on an
investor will be repaid equity index.
based on the S&P 500.

Distinguishing between conversion and redemption options

Standard conversion options allow for conversion of the debt into a fixed or substantially fixed number
of shares. Standard redemption features, such as put and call options, give the holder the right to put
the debt to the issuer (or the issuer the right to call the debt from the holder) at a stated amount to be
paid in cash or shares. Some instruments provide for conversion into a variable number of shares, with
the number of shares determined at the time of conversion based on the fair value or price of the
shares at the conversion date. Such a feature is designed to ensure that the holder receives a

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predetermined amount of value paid in whatever number of shares it takes to arrive at that value. In
other words, the value that the holder is expected to receive upon conversion is not expected to vary
based on changes in the value of the underlying shares. We believe it would be appropriate to analyze
such a feature as a redemption option rather than a conversion option when performing the embedded
derivative analysis. This can have significant ramifications to the analysis because although options to
convert to shares are not clearly and closely relate to a debt host contract, redemption options may be.
Additionally, net settlement would generally exist under ASC 815-10-15-107 for conversion features in
debt host contracts that are in substance redemption options because the value of the feature is not
expected to vary with changes in the fair value of the underlying shares.

3.3.1.6 Conversion options

A convertible debt instrument is one of the most common hybrid instruments. Convertible debt is debt
that contains a conversion feature which allows the investor or holder to convert the debt into the equity
shares of the issuer rather than receive repayment of the debt principal in cash.
As noted in ASC 815-15-25-51, equity conversion options are not clearly and closely related to a debt
host contract because the underlying value of an equity conversion option is dependent upon the value
of an equity interest.
As part of the analysis to determine if a conversion option should be separately recognized as a
derivative, an entity must determine whether the conversion option would meet the definition of a
derivative if it was a freestanding instrument. This often hinges on whether the net settlement
characteristic of a derivative is met (because the other characteristics typically are), and for the issuer
of the convertible instrument, whether the conversion option qualifies for a derivative scope exception.
To determine whether the net settlement characteristic of a derivative is met, an entity should consider
if the convertible instrument has any provisions whereby the holder can get the as-converted value in
cash. For example, contractual net settlement may exist in the form of a put or redemption option that
allows the holder to receive the greater of face or the as-converted value in cash.
If there are no contractual provisions for net settlement, an entity would next generally consider
whether the shares that will be delivered upon conversion are readily convertible to cash.
The determination of whether the shares are readily convertible to cash needs to be considered on an
ongoing basis throughout the life of a contract. Delisting an IPO or significant changes in the level of
trading activity are examples of factors that could influence the conclusion as an entity should consider
whether the smallest increment of shares that would be delivered in accordance with each individual
contract is small relative to the daily transaction volume. Assume for example that a debt instrument
can be converted at a conversion price that would result in the issuance of 100,000 shares of publicly
traded common stock. The average daily trading volume associated with the common stock is 50,000
shares. If the debt instrument could only be converted in total, the 100,000 shares into which it would
be converted is large relative to the daily transaction volume, and the common shares would not be
considered to be readily convertible to cash. Many instruments permit conversion in whole or in part
(i.e., in whatever increment the holder elects), in which case, generally, the common shares would be
considered to be readily convertible to cash if they are actively traded. Refer to the guidance beginning
at ASC 815-10-15-130 and Example 7 beginning at ASC 815-10-55-99 for additional information.
If the determination is made that an option to convert to equity in a debt host contract is a derivative,
the issuer would need to determine whether the conversion option meets the scope exception for
certain contracts involving an entity’s own equity in ASC 815-10-15-74(a). Refer to A Guide to
Accounting for Debt and Equity Instruments in Financing Transactions for further information on the
embedded conversion option analysis and this scope exception from the perspective of the issuer. The
investor or holder cannot qualify for this scope exception.

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3.3.1.7 Term extension feature

A term extension feature is defined in ASC 815-15-25-44 as an embedded derivative that does one of the
following two things:
• Unilaterally enables one party to significantly extend the remaining term to maturity of an instrument
• Automatically significantly extends the remaining term of an instrument upon the occurrence of
specific events or conditions
ASC 815-15-25-44 also indicates that a term extension feature “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.” As a
result, if an embedded term extension feature does not reset the interest rate on an instrument, it is not
clearly and closely related to the debt host contract. Additionally, a term-extension feature that could
prevent an investor from recovering substantially all its initial recorded investment is also not clearly and
closely related to the debt host contract, consistent with the guidance in ASC 815-15-25-26.
Term extension features that are not clearly and closely related to the host contract may require separate
recognition as a derivative if all the characteristics of a derivative are present, including net settlement.
Term-extension features that are exercisable at the option of the borrower may meet the loan
commitment scope exception in ASC 815-10-15-69 to 15-71.
3.3.1.8 Equity indexed payments
As explained in ASC 815-15-25-49 in the context of interest payments that are indexed to equity, an
equity related derivative embedded in a debt instrument is required to be separated from the host contract
and accounted for as a derivative instrument. This would be the case whether the equity indexed
payments are based on the price of a specific common stock or on a basket of equity instruments
because the changes in fair value of an equity interest and the interest yield on a debt instrument are not
clearly and closely related.
3.3.1.9 Illustrative examples of applying the embedded derivative guidance to common features
within debt host contracts
The chart that follows provides RSM’s insights on whether the first and third criterion in ASC 815-15-25-1
are met for common embedded features found in debt host contracts. Criterion one is that the economic
characteristics and risks of the potential embedded derivative are not clearly and closely related to the
economic characteristics and risks of the host contract, and criterion three is that the embedded feature
meets the definition of a derivative and is not eligible for a derivative scope exception. If both criteria are
met and the hybrid instrument is not accounted for at fair value through earnings in its entirety, the
embedded feature would require separate recognition as a derivative.

Are the economic characteristics and

risks of the potential embedded Does the embedded feature meet the
derivative not clearly and closely definition of a derivative and is not
related to the host contract? eligible for a scope exception?

Debt host contract, including preferred shares that are more akin to debt:

Conversion Yes, the economic characteristics and Possibly. A conversion option would
options risks of an option to convert a debt generally meet the definition of a
(Note 1) instrument into equity shares are not derivative if net settlement exists (e.g.,
clearly and closely related to a debt host contractually or because the conversion
contract. shares are actively traded). The price of

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Are the economic characteristics and

risks of the potential embedded Does the embedded feature meet the
derivative not clearly and closely definition of a derivative and is not
related to the host contract? eligible for a scope exception?
the shares is an underlying, the number
of shares it can convert into is a notional
amount and there is generally no or little
initial net investment associated with the
conversion option.
From the issuer’s perspective, it may
qualify for the scope exception for certain
contracts involving an entity’s own equity.

Redemption An entity should consider ASC 815-15-25- Embedded features that can accelerate
or other 40 through 25-42, as well as ASC 815-15- the maturity typically meet the definition of
features that 25-26 and 25-37 (as relevant) to a derivative in a debt host contract.
can determine if the economic characteristics Interest rates, and for contingent features,
accelerate and risks of the feature are not clearly and the occurrence of the contingency are
payoff closely related to a debt host contract. underlyings. The face amount of the debt
including (or face plus a premium) is generally the
put/call and notional amount. There is generally no or
prepayment little initial net investment associated with
options or the feature. The net settlement
requirements characteristic is present for features that
can accelerate the maturity of a debt host
contract due to ASC 815-10-15-107.
Generally, embedded features require no
or minimal initial net investment.

Interest rate The economic characteristics and risks of Interest rate floors, caps and collars
floors, caps, interest rate floors, caps and collars are typically meet the definition of a
collars often considered to be clearly and closely derivative. These instruments have an
related to a debt host contract. As a underlying (i.e., an interest rate or index)
result, this criterion would not be met. and have a notional amount (i.e., the face
However, an entity should carefully amount). Further, these embedded
consider the guidance that begins at ASC features typically require no or little initial
815-15-25-26 in making this net investment, and net settle as
determination. described in ASC 815-10-15-100 through
a one-way transfer of cash (When making
the interest payments, neither party is
required to deliver an asset with a
principal amount equal to the notional
amount).

Default Default interest and other credit sensitive Features that provide for default interest
interest and payments are considered to be clearly and other credit sensitive payments
other credit and closely related to a debt host contract typically meet the definition of a
sensitive such that this criterion would not be met if derivative. These features have an
payments the default interest or payments are underlying because they provide for a

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Are the economic characteristics and

risks of the potential embedded Does the embedded feature meet the
derivative not clearly and closely definition of a derivative and is not
related to the host contract? eligible for a scope exception?
based on the default or change in credit payment based on an occurrence or
worthiness of the obligor (ASC 815-15-25- nonoccurrence of an event (e.g., a
46 and 25-47). change in credit rating or an event of
default). Further, they typically have a
payment provision or notional amount
(e.g., face amount of the debt to which a
default rate of interest will be applied). In
addition, these features typically require
no or little initial net investment, and net
settle as described in ASC 815-10-15-100
through a one-way transfer of cash
(When making the interest or other credit
sensitive payments, neither party is
required to deliver an asset with a
principal amount equal to the notional
amount).

Term An entity should consider ASC 815-15-25- Term extending options typically do not
extending 44 to determine if the economic meet the definition of a derivative unless
options characteristics and risks of the feature are net settlement exists. Further, a term
not clearly and closely related to a debt extending option would not be accounted
host contract. for as a derivative if meets the loan
commitment scope exception.

Commodity Yes, the economic characteristics and Features embedded in a debt instrument
or equity risks of a commodity or equity index are with payments that are based on a
indexed not clearly and closely related to a debt commodity price or index or an equity
payments host contract. price or index typically meet the definition
of a derivative. The commodity price or
index or equity price or index is
considered an underlying. Further, these
features typically have a payment
provision or notional amount to which the
index is applied and require no or minimal
initial net investment. Typically, these
features net settle as described in ASC
815-10-15-100 because they are settled
by a one-way transfer of cash (Neither
party is required to deliver an asset (e.g.,
commodity or equity security) that is
associated with the underlying.

Inflation Generally, no. Inflation indexed payments The definition of a derivative typically
indexed are considered to be clearly and closely would be met because the embedded
payments related to a debt host contract unless a features that provide for inflation indexed
significant leverage factor is involved or payments have an underlying (i.e.,

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Are the economic characteristics and

risks of the potential embedded Does the embedded feature meet the
derivative not clearly and closely definition of a derivative and is not
related to the host contract? eligible for a scope exception?
the inflation rate is not a relevant rate in inflation index), and typically, have a
the economic environment for the notional amount (the payment amount to
currency in which the debt instrument is which the index is applied), require no or
denominated (ASC 815-15-25-50). little initial net investment, and net settle
under ASC 815-10-15-100 in the form of
a one-way transfer of cash (Neither party
is required to deliver an asset that is
associated with the underlying (i.e., an
inflation-sensitive asset) and has a
denomination equal to the notional
amount).

Note 1: Some instruments provide for conversion into a variable number of shares, with the number of shares
determined at the time of conversion based on the fair value of the shares at that time or the price at which shares
were issued in a qualified financing event. Such a feature is designed to ensure that the holder receives a
predetermined amount of value paid in whatever number of shares it takes to arrive at that value. In other words,
the value that the holder is expected to receive upon conversion is not expected to vary based on changes in the
value of the underlying shares. For these reasons, features such as this are evaluated as redemption features
rather than conversion options.
3.3.2 Hybrid instruments with an equity host contract
This section generally applies to hybrid instruments in the form of a share when the nature of the host
contract is determined to be more equity-like than debt-like. Reference should be made to the preceding
section entitled Hybrid instruments with a debt host contract when the nature of the host contract is
determined to be more debt-like. Refer to Section 3.2.1.1 of this chapter for additional guidance on
determining the nature of a hybrid instrument in the form of a share that has characteristics of both debt
and equity.
As explained in ASC 815-15-25-16, if the host contract contains a residual interest in an entity, its
economic characteristics and risks are considered akin to an equity instrument. As a result, an embedded
derivative would need to possess mostly equity characteristics and risks (related to the same entity) for it
to be considered clearly and closely related to the host contract.
3.3.2.1 Redemption options (Put and (or) call options)
It is not uncommon for preferred or similar shares to have embedded redemption or put options that allow
the holder to return (put) the shares to the issuer in exchange for cash or other assets, either on or after a
specified date, or upon the occurrence of a contingent event such as a change in control. Issuer call
options are also prevalent in preferred or similar shares, whereby the issuer decides if it wants to pay
cash or other assets in exchange for a return of the shares. As explained in ASC 815-15-25-20,
embedded put and call options are not clearly and closely related to equity host contracts. As such, when
these features are present in a hybrid instrument with an equity host contract that is not accounted for at
fair value through earnings and meet the definition of a derivative, they generally require separate
recognition as a derivative. (The issuer would not account for embedded put and call options as
derivatives if all the requirements for the scope exception in ASC 815-10-15-74(a) are met. Refer to
Section 2.3.11.1 of Chapter 2 for further discussion on this scope exception).

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3.3.2.2 Conversion options

An equity instrument may contain an option whereby automatically, contingently, or at the holder’s option
the instrument will convert from one class of the issuer’s shares to another class of the issuer’s shares
(most commonly, from preferred stock to common). An embedded option to convert into equity generally
has economic characteristics and risks that are clearly and closely related to an equity host contract and
would therefore not be accounted for separately as a derivative.
3.3.2.3 Rights offering features
Rights offering features may provide the holders of equity shares with the right to purchase more of the
issuer’s shares and are often granted in conjunction with an initial offering. These rights may either be
freestanding or embedded in the outstanding equity shares issued at the time the rights are granted.
Generally, embedded rights offering features to purchase additional shares have economic
characteristics and risks that are clearly and closely related to an equity host contract and therefore do
not require separate recognition as a derivative. Refer to the discussion of “Delayed issuance of preferred
or other stock” in our publication, A guide to accounting for debt and equity instruments in financing
transactions, for guidance useful in determining if the rights are embedded or freestanding and in
understanding the accounting ramifications based on that determination.
3.3.2.4 Illustrative examples of applying the embedded derivative guidance to common features
within equity host contracts
The chart that follows provides RSM’s insights on whether the first and third criterion in ASC 815-15-25-1
are met for common embedded features found in equity host contracts. (Refer to the chart in Section
3.3.1.9 of this chapter if the host contract was deemed to be more debt-like). Criterion one is that the
economic characteristics and risks of the potential embedded derivative are not clearly and closely
related to the economic characteristics and risks of the host contract, and criterion three is that the
embedded feature meets the definition of a derivative and is not eligible for a derivative scope exception.
If both criteria are met and the hybrid instrument is not accounted for at fair value through earnings in its
entirety, the embedded feature would require separate recognition as a derivative.

Are the economic characteristics and

risks of the potential embedded Does the embedded feature meet the
derivative not clearly and closely definition of a derivative and is not
related to the host contract? eligible for a scope exception?

Equity host contract:

Option to No, the economic characteristics and Possibly. A conversion option would
convert to risks of an option to convert a particular generally meet the definition of a
another class class of equity shares into another class derivative if net settlement exists (e.g.,
of equity of equity shares are clearly and closely contractually or because the conversion
(Note 1) related to an equity host contract. shares are actively traded). Whether the
conversion option is a derivative in an
equity host contract is generally irrelevant
because the economic characteristics and
risks of such options are clearly and
closely related to their equity host
contract such that separate derivative
accounting is not required or appropriate.

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Are the economic characteristics and

risks of the potential embedded Does the embedded feature meet the
derivative not clearly and closely definition of a derivative and is not
related to the host contract? eligible for a scope exception?

Redemption Yes, the economic characteristics and Possibly. Redemption feature(s)

features risks of a redemption option are not embedded in an equity host contract
put/call clearly and closely related to an equity typically meet the definition of a derivative
options host contract. if net settlement exists. Most redemption
features are settled gross in that an asset
that is associated with the underlying
(price of the shares) and notional (e.g.,
redemption amount) exchanges hands.
ASC 815-10-15-107 does not apply to
embedded features in an equity host
contract. However net settlement may
exist if contractually provided for (e.g., in
the certificate of designation) or if the
shares to be redeemed are actively
traded).
From the issuer’s perspective, redemption
options in an equity host contract may
qualify for the scope exception for certain
contracts involving an entity’s own equity.

Note 1: Some instruments provide for conversion into a variable number of shares, with the number of shares
determined at the time of conversion based on the fair value of the shares at that time or the price at which shares
were issued in a qualified financing event. Such a feature is designed to ensure that the holder receives a
predetermined amount of value paid in whatever number of shares it takes to arrive at that value. In other words,
the value that the holder is expected to receive upon conversion is not expected to vary based on changes in the
value of the underlying shares. For these reasons, features such as this are evaluated as redemption features
rather than conversion options.
3.3.3 Hybrid instruments with a lease host contract
Determining whether an embedded derivative in a lease contract is clearly and closely related to the
lease host contract involves a thought process that is similar to that used for a debt host contract. In other
words, the nature of the host contract is generally determined by excluding the potential embedded
derivative(s) and focusing on the remaining host contract. Therefore, the nature of the host contract for a
hybrid instrument in the form of a lease is typically a lease and any embedded derivatives that do not
have economic characteristics and risks that are clearly and closely related to a lease would require
further attention to determine if separate recognition as a derivative is required.
3.3.3.1 Illustrative examples of applying the embedded derivative guidance to common features
within lease host contracts
The chart that follows provides RSM’s insights on whether the first and third criterion in ASC 815-15-25-1
are met for common embedded features found in lease host contracts. Criterion one is that the economic
characteristics and risks of the potential embedded derivative are not clearly and closely related to the
economic characteristics and risks of the host contract, and criterion three is that the embedded feature
meets the definition of a derivative and is not eligible for a derivative scope exception. If both criteria are
met and the hybrid instrument is not accounted for at fair value through earnings in its entirety, the
embedded feature would require separate recognition as a derivative.

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Are the economic characteristics and

risks of the potential embedded Does the embedded feature meet the
derivative not clearly and closely definition of a derivative and is not
related to the host contract? eligible for a scope exception?

Lease host contract:

Inflation No, rental payments for the use of leased Generally, the derivative analysis is not
indexed assets and adjustments for inflation are relevant because the economic
rentals considered to have economic characteristics and risks of inflation
characteristics and risks that are clearly indexed rentals are clearly and closely
and closely related to a lease host contract related to their lease host contract unless
unless a significant leverage factor is a significant leverage factor is involved.
involved. (ASC 815-15-25-21) However, if a significant leverage factor is
involved, the derivative analysis is
relevant. The definition of a derivative
typically would be met because the
embedded features that provide for
inflation indexed rentals have an
underlying (i.e., inflation index), and
typically, have a notional amount (the
payment amount to which the index is
applied), require no or little initial net
investment, and net settle under ASC
815-10-15-100 in the form of a one-way
transfer of cash. (Neither party is required
to deliver an asset that is associated with
the underlying [i.e., an inflation-sensitive
asset] and has a denomination equal to
the notional amount).

Interest-rate No, interest-rate adjusted rentals are Because the economic characteristics
adjusted considered to have economic and risks of interest-rate adjusted rentals
rentals characteristics and risks that are clearly are considered clearly and closely related
and closely related to a lease host contract to a lease host contract, the derivative
under ASC 815-15-25-22. analysis is not relevant.

Feature that Both the clearly and closely related criterion and whether the feature meets the
adjusts definition of a derivative are irrelevant because the embedded derivative would qualify
lease for the scope exception in ASC 815-10-15-59(d) because the underlying on which
payments settlement is based is the sales of one of the parties to the contract.
based on
the lessee’s
sales (e.g.,
monthly rent
payable of
$15,000,
plus 2% of
the lessee’s
gross sales

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Are the economic characteristics and

risks of the potential embedded Does the embedded feature meet the
derivative not clearly and closely definition of a derivative and is not
related to the host contract? eligible for a scope exception?
for the
month

Purchase Both the clearly and closely related criterion and whether the feature meets the
option at the definition of a derivative are generally irrelevant because an option to purchase a
end of the leased asset would typically qualify for the scope exception in ASC 815-10-15-59(b) as
lease term long as the underlying leased asset on which settlement is based is a nonfinancial asset
that is unique, not readily convertible to cash and owned by the party that would not
benefit under the option from an increase in the fair value of the leased asset.

3.3.4 Hybrid instruments with an insurance host contract

An entity will need to assess its insurance contracts to determine whether any contain an embedded
derivative that must be accounted for separately. ASC 815-15-55 provides implementation guidance for
the following types of insurance contracts:
• Dual-trigger insurance contracts (ASC 815-15-55-12)
• Variable annuities contracts (ASC 815-15-55-54 to 55-56)
• Payment options for variable annuity contracts (ASC 815-15-55-57 to 55-61)
• Equity-indexed annuity contracts (ASC 815-15-55-62 to 55-72)
• Equity-indexed life insurance contracts (ASC 815-15-55-73 to 55-76)
• Modified coinsurance arrangements (ASC 815-15-55-107 to 55-109)
3.3.4.1 Dual-trigger insurance contracts
Dual-trigger insurance contracts are policies that pay the holder benefits only if two events occur.
Although the contracts or embedded derivatives within them often qualify for a derivative scope
exception, ASC 815-15-55-12 explains that if an insurance entity issues a contract that “involves
essentially assured amounts of cash flows” that are based on insurable events that are highly probable of
occurring, the entity should separate an embedded derivative related to changes in the separate pre-
identified variable for that portion of the contract and account for it as a derivative instrument. Refer to
Section 2.3.3 of Chapter 2 for an illustration of the concept of essentially assured.
3.3.4.2 Variable annuities in general
As noted in ASC 815-15-55-54, variable annuities are similar to variable life insurance contracts in that
they enable the policyholder to direct the asset mix of its investment account among a variety of mutual
funds, which are typically comprised of equities and (or) bonds. The policyholder may be able to elect
from various payment options at the end of the accumulation period (i.e., the period during which the
policy holder pays premiums).
These variable annuity contracts typically provide that upon the death of the policyholder, the beneficiary
will receive the greater of the value of the investment account or a minimum death benefit guarantee. The
minimum death benefit guarantee is usually limited to premiums paid plus a minimum stated return on
those premiums (e.g., 3 or 4%).

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While variable annuities generally do not fall within the scope of ASC 815, certain components require
further consideration. The following table compiled from the guidance that begins at ASC 815-15-55-55
discusses various components (including payment options) of variable annuities and for each component,
indicates whether it should be accounted for separately as a derivative and the basis for that conclusion:

Accounted for
Component separately? Basis for conclusion

Death benefit component No ASC 815-10-15-53(a) excludes this component from the
(i.e., the previously scope of ASC 815 because the payment of the death
discussed minimum death benefit results from an identifiable insurable event rather
benefit guarantee to the than the changes in an underlying as discussed in ASC
extent it exceeds the fair 815-15-55-55(a). Additionally, upon the adoption of ASU
value of the account) 2018-12, death benefits that meet the criteria of market
risk benefits are excluded from the scope of ASC 815.

Investment component No As discussed in ASC 815-15-55-55(b), the investment

(i.e., the previously component of a traditional variable annuity is not
discussed investment considered a derivative instrument subject to ASC 815.
account of traditional
In accordance with ASC 815-15-55-56, this guidance
annuities)
should not be applied to other seemingly similar
structures by analogy.

Investment component Depends In accordance with ASC 815-15-55-55(b), such an

consisting of an equity- investment component would be accounted for
index-based interest separately as a derivative if it meets all the conditions in
annuity ASC 815-15-25-1. Upon the adoption of ASU 2018-12,
market risk benefits are excluded from the scope of ASC
815.

Investment account No In accordance with ASC 815-15-55-55(c), an investment

surrender right at fair account surrender right at fair value is not within the
value scope of ASC 815 because it is exercised only at the
fund fair value and relates to a traditional variable
annuity.
In accordance with ASC 815-15-55-56, this guidance
should not be applied to other seemingly similar
structures by analogy.

Payment options at the Depends In accordance with ASC 815-15-55-55(d), upon the
end of the accumulation adoption of ASU 2018-12, payment options are not
period subject to ASC 815 if the payment is a market risk
benefit within the scope of ASC 944. Prior to the
adoption of ASU 2018-12, payment alternatives are
subject to the scope of ASC 815 if interest rates, or other
underlying variables affect the fair value.

A guarantee of a minimum No The net settlement characteristic of a derivative is not

interest rate that is used to met because settlement can be achieved only by the
compute periodic annuity investment of the account balance in lieu of an

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Accounted for
Component separately? Basis for conclusion
payments if and when the immediate payout. Refer to ASC 815-10-15-99 and 815-
policyholder chooses to 15-55-58 for further information.
annuitize
Upon the adoption of ASU 2018-12, the embedded
derivative would not be subject to ASC 815 if it is
considered a market risk benefit given the scope
exception that begins at ASC 815-10-15-52.

A guaranteed minimum Generally, no The net settlement characteristic of a derivative is not

account value to annuitize met during the accumulation phase because the
if and when a policyholder policyholder would only realize the benefit of the
chooses to annuitize guaranteed minimum account value by annuitizing, and
therefore receiving, the benefit over the payout period.
However, the net settlement characteristic of a derivative
would be considered to exist, and an embedded
derivative recognized during the accumulation phase if
either the policyholder can withdraw all or part of the
guaranteed account balance during the payout period, or
the payout period is unrealistically short (e.g., one year).
Refer to ASC 815-10-55-59 for further information. This
guidance is superseded upon the adoption of
ASU 2018-12.

A guaranteed minimum No The net settlement characteristic of a derivative is not

level of periodic annuity met during the accumulation phase because the
payments during the policyholder would only realize the benefit of the
payout phase if and when guaranteed minimum level of periodic annuity payments
a policyholder chooses to by annuitizing, and therefore receiving, the benefit over
annuitize the payout period. This assumes that the contract is
annuitized at its contract value and does not have a
minimum guaranteed account value as described in the
preceding row.
Refer to ASC 815-10-55-60 for further information. This
guidance is superseded upon the adoption of
ASU 2018-12.

3.3.4.3 Equity-indexed annuities

An equity-indexed annuity is a deferred fixed annuity that has a guaranteed minimum interest rate plus a
contingent return that is based on an internal or external equity index (e.g., the S&P 500 Index). The
guaranteed contract value is typically designed to meet certain regulatory requirements. Equity-indexed
annuities usually have minimal mortality risk and as a result, are classified as investment contracts
pursuant to ASC 944. Because equity-indexed annuities often do not have specified maturity dates, these
contracts remain in the accumulation phase until the customer surrenders the contract or chooses to
annuitize. Generally, a customer can surrender its contract at any time and receive its account value less
any surrender charges.
ASC 815-15-55-63 explains that the following are the two basic designs of equity-indexed annuities.

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a. The periodic ratchet design, where in the annual version, the customer receives the greater of the
appreciation in the equity index during a series of one-year periods (ending on each policy
anniversary date) or the guaranteed minimum fixed rate of return over that period
b. The point-to-point design, where the customer receives the greater of the appreciation in the
equity index during a specified period (for example, five or seven years, starting on the policy
issue date) or the guaranteed minimum fixed rate of return over that period.
Refer to ASC 815-15-55-64 to 55-72 for further explanation of, and accounting guidance relevant to
equity-indexed annuities. Example 14 that begins at ASC 815-15-55-227 illustrates accounting and
valuation issues associated with an equity-indexed annuity that has a minimum account value and
participates in equity returns.
3.3.4.4 Equity-indexed life insurance contracts
An equity-indexed life insurance contract combines term life insurance with an investment feature. The
death benefit amount of an equity-indexed life insurance contract is based on the amount chosen by the
policyholder plus the account value. The policyholder’s account value is based on the cumulative deposits
plus the positive returns based on an equity index (e.g., the S&P 500 Index). The cash surrender value of
the contract is also linked to the equity index. In some contracts, the death benefit amount is dependent
on the overall return on the index.
The economic characteristics and risks of the equity-indexed components of these arrangements are not
considered to be clearly and closely related to the economic characteristics and risks of an insurance
contract. Therefore, an entity should consider whether any equity-indexed components require separate
accounting as a derivative instrument under ASC 815-15-25-1. As indicated in ASC 815-10-15-67, if the
policyholder accounts for its equity-indexed life insurance contract in accordance with ASC 325-30, the
insurance contract is not subject to ASC 815. As a result, the policyholder would not account for the
embedded derivative separate from the insurance contract.
Refer to ASC 815-15-55-73 to 55-76 for accounting guidance on equity-indexed life insurance contracts.
3.3.5 Hybrid instruments with an executory host contract
Executory contracts often do not contain the net settlement characteristic of a derivative. As a result, such
a contract generally does not meet the definition of a derivative in its entirety, but should be evaluated to
assess whether it contains any embedded derivative(s) (e.g., caps, and floors) that may be required to be
accounted for separately. If an executory contract does meet the definition of a derivative in its entirety,
then the entity may elect to apply the normal purchases and normal sales scope exception discussed in
Section 2.3.2 of Chapter 2 if the contract qualifies as such.
The following is a list of examples of embedded derivatives that may be found in an executory contract for
the purchase or sale of raw materials, supplies, or services:
• Price caps and floors
• Price adjustments
• Foreign-currency swaps or options
• Commodity forwards
• Commodity options

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3.3.5.1 Caps and floors embedded in purchase contracts

Guidance on caps and floors that are embedded in purchase contracts is provided in ASC 815-15-25-19.
The economic characteristics and risks of a floor and cap on the price of an asset embedded in a
contract to purchase that asset are clearly and closely related to the purchase contract, because the
options are indexed to the purchase price of the asset that is the subject of the purchase contract.
Refer to Example 6 (paragraph 815-15-55-114) for an illustration of such options.
Example 6 that begins at ASC 815-15-55-114 is useful in understanding why the purchase contract in its
entirety does not meet all the characteristics of a derivative. However, the embedded cap and floor do.
3.4 Accounting for hybrid instruments
Pursuant to ASC 815-15-25-4 and 25-5, an entity may elect to account for an entire hybrid instrument at
fair value, with changes in fair value recognized in earnings (except as noted in ASC 825-10-45-5 2), if the
hybrid instrument has an embedded derivative that requires bifurcation. If an entity does not make that
election, any embedded derivatives that meet the conditions in ASC 815-15-25-1 should be accounted for
as derivatives separately from the host contract. (Refer to 4.1.3 for a discussion of the presentation of
derivatives that have been separated from the host contract in the statement of financial position).
The following is a summary of the accounting treatment that an entity would apply when ASC 815 would
otherwise require separating the embedded derivatives from a host contract.

Accounting
component Accounting treatment

Embedded derivative The embedded derivative is reported on the statement of financial position at
(ASC 815-10-35) fair value and generally changes in its fair value are reported in earnings. If
the embedded derivative is designated as a hedging instrument in a cash flow
hedge, changes in its fair value would be recognized in accordance with ASC
815-30-35. However, it is not common in our experience for an embedded
derivative to be designated as a hedging instrument.

Host contract (ASC The host contract that remains after separating an embedded derivative(s) is
815-15-25-54) accounted for based on the accounting guidance that applies to similar
contracts that do not contain an embedded derivative. For example, assume
a conversion option embedded in a hybrid convertible debt instrument
requires separate recognition as a derivative. The convertible debt was
issued for proceeds of $10 million and the fair value of the conversion option
derivative was $1 million at the issuance date. The host contract that remains
after separately recognizing the conversion option at its $1 million fair value is
accounted for like a debt instrument without a conversion option. The debt
host contract will have an initial carrying amount of $9 million with the $1
million discount created through the recognition of the conversion option
accounted for through the application of the interest method described in ASC
835-30.

2ASC 825-10-45-5 requires changes in the fair value of a financial liability accounted for at fair value that
are attributable to a change in instrument-specific credit risk to be recognized separately in other
comprehensive income.

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Accounting
component Accounting treatment

Hybrid instrument if The entire hybrid instrument would be accounted for at fair value with
embedded changes in fair value reported in earnings (except as noted in ASC 825-10-
derivative(s) cannot be 45-5) if an embedded derivative that requires separate recognition under ASC
reliably identified and 815-15-25-1 cannot be reliably identified or measured. This circumstance is
measured (ASC 815- expected to be unusual. A hybrid instrument that is accounted for at fair value
15-25-52 and 25-53) through earnings cannot be designated as a hedging instrument.

3.4.1 Allocating basis

In accordance with ASC 815-15-30-2, the basis of a hybrid instrument (generally the proceeds associated
with it) is allocated between the embedded derivative and the host contract to determine each of their
carrying values. The amount allocated to the embedded derivative upon its initial recognition is its fair
value at that time. The remainder is allocated to the host contract. This is illustrated with a convertible
debt instrument in the preceding table.
There are nuances in determining the fair value of a separated embedded derivative that are summarized
in the following table:

Type of embedded
derivative Determination of fair value

Non-option based Generally, for initial and ongoing valuation purposes, an entity should
(ASC 815-15-30-4 to establish the terms of a non-option embedded derivative (e.g., forward
30-5) contract) such that its fair value will equal zero upon its initial recognition. This
means that an entity would have to adjust the explicit terms of an off-market
embedded derivative (generally its forward price) to be reflective of market
terms at the time of initial recognition to result in the initial zero fair value.
Refer to Example 12 beginning at ASC 815-15-55-160 for an illustration.

Option based (ASC Unlike a non-option embedded derivative, an option based embedded
815-15-30-6) derivative can have a value other than zero upon its initial recognition. In
other words, the contractual terms of the embedded option are used in
determining the fair value of the option, even if those terms (e.g., strike price)
are off-market.

Note: When estimating the fair value of embedded derivatives separately from the fair value of the non-derivative
portions of a contract, it is important to ensure that all relevant features are considered but not double-counted in
the analysis. Consider for example a debt instrument that has two embedded features that require recognition as
a derivative, namely a conversion option, whereby the holder can convert the debt into a stated number of the
issuer’s common stock, and an option for the holder to put the debt back to the issuer for 1.5 times face value if
there is a change in control. The debt also contains an option for the issuer to prepay. However, that option does
not meet all the requirements in ASC 815-15-25-1 and therefore is not required to be recognized as a derivative.
Determining the fair value of the embedded derivatives is complex in that it is not as simple as determining the
value of the conversion option in isolation and adding that to the value of the change in control put option (also
determined in isolation). Such an approach would overstate the value of the derivatives in that the holder cannot
both exercise the put option and the conversion option. In addition, the fact that the issuer can prepay the debt
adds an additional valuation complexity because if the issuer does prepay, the period of time during which the
put or conversion option can be exercised will be reduced, a fact that also impacts the value of the embedded

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Type of embedded
derivative Determination of fair value
derivatives. As such, complex valuation models such as Monte Carlo simulations are often necessary when
valuing embedded derivatives.

In accordance with ASC 815-15-25-7 through 25-10, if a hybrid instrument contains more than one
embedded derivative that requires separate accounting, an entity should bundle those embedded
derivatives together as a single, compound embedded derivative and report the compound derivative as a
single unit of account. However, that compound embedded derivative should not include any features that
are clearly and closely related to the host contract as such features would not require derivative
recognition under ASC 815-15-25-1.
3.4.2 Asymmetry amongst counterparties
The guidance in ASC 815-15 on embedded derivatives generally applies to both parties to the contract.
However, it is possible that the two parties could reach different conclusions as to whether an embedded
derivative should be accounted for separately. For example, certain derivative scope exceptions only
apply to one party to the transaction. (An example includes the scope exception in ASC 815-10-15-74 for
certain contracts involving an entity’s own equity.) It is also possible that an investor that acquires a debt
instrument as part of a business acquisition or in the secondary market could reach a different conclusion
than the original investor or issuer as to whether an embedded interest rate derivative or put or call option
requires separate accounting. This is because the analysis to determine if an embedded derivative has
characteristics and risks that are clearly and closely related to the host contract should be performed at
the time the instrument is issued or acquired by the reporting entity. Thus, an entity that acquires the
instrument after its initial issuance date would generally be acquiring it and applying the guidance at
different points in time and potentially different circumstances (e.g., the issuer may have issued the
instrument at face however a subsequent acquirer may have paid a premium or discount on the
secondary market which could impact conclusions reached under ASC 815-15-25-26 and 25-42).
3.4.3 Timing and frequency of the embedded derivative assessment
The analysis to determine whether an embedded derivative is required to be accounted for separately
should be performed upon entering into the contract or financial instrument. Certain conclusions need to
be reassessed on an ongoing basis. Although the analysis to determine if an embedded derivative meets
the clearly and closely related condition in ASC 815-15-25-1(a) and the embedded foreign currency
derivative scope exception in ASC 815-15-15-10 are generally one-time assessments, the determination
of whether the embedded derivative meets the definition of a derivative and in some cases whether it
qualifies for a derivative scope exception could require reassessment each reporting period. Additionally,
it is generally necessary to reperform the embedded derivative analysis if an embedded feature or host
contract is modified.
The table below provides examples of why the accounting treatment for an embedded derivative may
change, thus emphasizing the importance of reassessing conclusions reached on whether a derivative
that is embedded in a hybrid instrument requires separate recognition.

Situation Accounting ramifications

Changes in the trading Factors such as an IPO, sustained changes in daily trading volume and listing
volume of an issuer’s or delisting of the shares on a national stock exchange can impact the
shares or the determination of whether the shares underlying an embedded conversion
existence of a market option are readily convertible to cash and as such whether the net settlement
mechanism characteristic of a derivative in ASC 815-10-15-119 is met. Similarly, as new

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Situation Accounting ramifications

markets develop or contract, conclusions reached about whether a market
mechanism exists may change.

Change in whether the A change in circumstance may cause a feature that qualified for the derivative
criteria to apply the scope exception in ASC 815-10-15-74(a) to no longer qualify or conversely,
scope exception for cause a feature that initially did not qualify for the scope exception to newly
certain contracts qualify. This could be the case for example as the number of authorized
involving an entity’s shares are increased or as outstanding shares and commitments to issue
own equity are met shares change, impacting conclusions reached on whether the condition in
815-40-25-20 to apply the scope exception are met.

Instrument A hybrid instrument may be modified in a way that triggers a remeasurement

modification event such that it has a new basis. This would be the case for example if
there is an extinguishment of the hybrid instrument. To illustrate, if modified
debt is considered extinguished, its carrying value is adjusted to fair value,
which is likely at a premium or discount to the face amount. While generally
conclusions reached on whether an embedded feature has characteristics
and risks that are clearly and closely related to the host contract are not
reassessed, because the debt was extinguished, this would be viewed as
though new debt was issued. In light of the debt likely being “issued” at a
premium or discount, the conclusions reached on whether an embedded
redemption feature or interest rate feature is clearly and closely related to the
host contract when applying the guidance in ASC 815-15-25-26 and 25-42
may be impacted. Additionally, changes to the terms may impact conclusions
reached on whether an embedded feature is a derivative, and if so, whether it
qualifies for a scope exception.

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4. Presentation and Disclosure

4.1 General presentation requirements
Questions have arisen about the line-item presentation of derivatives in the financial statements. ASC
815 addresses the presentation of hedging results in the statement of financial performance, but is
otherwise not prescriptive on financial statement presentation. The following discussion summarizes the
guidance that is available about the presentation of derivatives, and includes observations of what we
have seen in practice.
4.1.1 Presentation on the statement of financial position
Derivatives should be recognized at their fair value in the statement of financial position (unless the
derivative is an interest rate swap, and the reporting entity qualifies for and elects to carry it at settlement
value under the Private Company Counsel’s simplified approach). Non-option derivatives can generally
be either an asset or liability depending on whether the derivative is in a favorable or unfavorable position
to the reporting entity as of the reporting date. Derivative assets and liabilities are distinct from the assets
or liabilities that they may hedge. Therefore, as noted in ASC 815-10-45-2, there is no support to net
derivative assets or liabilities on the statement of financial position against the items they hedge. For
example, given that an interest rate swap is a separate financial instrument from the debt that it may
hedge, it would not be appropriate to report the swap’s carrying amount in the same line item as the debt.
Upon the adoption of ASU No. 2022-01, Derivatives and Hedging (Topic 815), ASC 815-20-45-4
addresses the classification in the statement of financial position for portfolio layer method hedges and
indicates that if the hedged assets that are included in the same closed portfolio are presented in different
line items in the statement of financial position (e.g., debt securities and loans), the portfolio layer method
basis adjustment should be allocated to the assets’ associated line items using a systematic and rational
method.
4.1.1.1 Classification
An entity that prepares classified statements of financial position needs to determine the amount of
derivative assets and liabilities that it should classify as current. ASC 815 does not provide guidance for
making this determination; hence, as a result an entity should consider the general guidance in ASC 210-
10 for classifying current assets and liabilities. A somewhat unique aspect of derivatives is that the
expected cash flows that drive their fair value, and therefore carrying amount, may contractually occur on
multiple settlement dates and include a combination of inflows and outflows. As a consequence of this,
the carrying amount of individual derivatives may need to be broken out between current and noncurrent
classification as well as between asset and liability classification on the statement of financial position.
We believe an entity should classify a derivative based on the timing of its cash flows, which typically
occur on a stated contractual settlement date or dates. However, an entity should consider all factors
when determining the appropriate classification because there may be situations in which using the stated
contractual settlement date would not be appropriate. For example, we believe current liability
classification would be appropriate under ASC 210-10-45-7 regardless of the contractual settlement date
for a derivative that is in a net liability position and is due on demand (e.g., in the case of a default that
makes all amounts currently due and payable).
The following table addresses classification as current or noncurrent based on the contractual settlement
date or dates.

Settlement date Classification on the statement of financial position

Within 12 months of the Current

reporting period end

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Settlement date Classification on the statement of financial position

After 12 months of the reporting Noncurrent

period end

Multiple settlements both within Generally, the reported amount is separated into current and
12 months and after 12 months noncurrent portions, based on the expected timing and direction of
future cash flows. An example follows:
Entity A holds a pay fixed, receive variable interest rate swap that
matures in five years and has a positive fair value of $10 million as
of the reporting date. Entity A reviews the expected cash flows
computation that underlies the valuation of the swap and
determines that the $10 million positive value is a net number that
includes the following:
• Gross expected cash outflows with a net present value of
approximately $3 million in the next 12 months
• Gross expected cash inflows with a net present value of
approximately $13 million for the remaining term of the interest
rate swap (given that the variable interest rate is expected to
rise after 12 months)
Entity A reports this interest rate swap as a $3 million current
liability and $13 million noncurrent asset in its classified statement
of financial position.

4.1.1.2 Offsetting
It is not uncommon for an entity to have multiple derivatives outstanding with one or more counterparties,
some of which may be in an asset position and some of which may be in a liability position at any given
time. Although an entity may desire to record all similar derivative assets and liabilities net on the same
line item on the statement of financial position, it is not appropriate to offset derivative assets against
derivative liabilities and report the net amount unless a legal right of setoff exists and other requirements
beginning in ASC 815-10-45-5 are met. The following example illustrates this concept.

Example 4.1.1: Net presentation of derivative instruments

Bank A is a party to interest rate swaps with multiple loan customers, as well as with various dealers.
Bank A has no legal right to offset amounts owed to or from its loan customers against amounts owed
to or from the dealers on their respective swaps, nor can it legally offset amounts owed to or from one
dealer to another. However, its contractual arrangement with each dealer does give it a legally
enforceable right to offset amounts owed to and from that dealer. The following chart summarizes the
fair values of the various swaps that are outstanding at the reporting date and the statement of financial
position presentation assuming that Bank A qualifies and elects to offset the amounts related to
derivative contracts with the same counterparty:

Swaps with
individual loan Swaps with Swaps with
customers Dealer A Dealer B Total

Asset position $20,000,000 $2,000,000 $6,000,000 $28,000,000

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Liability position 5,000,000 10,000,000 7,000,000 22,000,000

Net asset position 6,000,000

Balance sheet Assets of $20MM Net liability of Net liability of Assets of $20MM
presentation and liabilities of $8MM $1 MM and liabilities of
$5MM $14MM

Because Bank A’s accounting policy is to offset derivative instruments and the related cash collateral
with the same counterparty under a master netting arrangement on the statement of financial position
in accordance with ASC 815-10-45-5, Bank A would present $20 million of assets and $14 million of
liabilities associated with the interest rate swaps. Conversely, if Bank A’s accounting policy was not to
offset, it would present $28 million of assets and $22 million of liabilities associated with the interest
rate swaps. In either case, it would not be appropriate to simply present a net asset of $6 million.

If an entity wishes to offset contracts with the same counterparty, it must make an accounting policy
election to do so and meet certain criteria. Specifically, offsetting the fair value of derivative contracts in a
loss position (liabilities) against the fair value of derivative contracts in a gain position (assets) on the
statement of financial position is permitted if the following “right of setoff” conditions from
ASC 210-20-45-1 are met:
a. Each of two parties owes the other determinable amounts.
b. The reporting party has the right to set off the amount owed with the amount owed by the other
party.
c. The reporting party intends to set off.
d. The right of setoff is enforceable at law.
The preceding conditions are the general requirements for offsetting. ASC 815-10-45-5 indicates that an
entity need not have the intent to set off (i.e., criterion c. above) when evaluating if derivatives and fair
value amounts recognized for rights or obligations to cash collateral with the same counterparty that are
subject to the same master netting arrangement can be offset. A master netting arrangement exists (as
described in ASC 815-10-45-5) if an entity has multiple contracts, whether for the same type of derivative
or for different types of derivatives, with a single counterparty that are subject to a contractual agreement
that provides for the net settlement of all contracts through a single payment in a single currency in the
event of default on, or termination of, any one contract. Standard International Swaps and Derivatives
Association (ISDA) master agreements typically contain such provisions and would thus constitute a
master netting arrangement if they are enforceable at law in the jurisdiction in which they are transacted.
If the above conditions are met, ASC 815-10-45-5 permits (but does not require) offsetting of fair value
amounts recognized for multiple derivatives and fair value amounts recognized for the right to reclaim
cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from the same
master netting arrangement as the derivatives. Fair value amounts for this purpose include amounts that
approximate fair value. The fair value recognized for some contracts may include an accrual component
for the periodic unconditional receivables and payables resulting from the contract, which also may be
offset.
As indicated in ASC 815-10-45-6, an entity makes an accounting policy election to offset fair value
amounts in accordance with the preceding paragraphs. Once an entity establishes its accounting policy
for offsetting, the entity must apply its policy consistently. An entity should not offset the fair value
amounts recognized for derivatives without also offsetting the fair value amounts recognized for the right
to reclaim cash collateral or the obligation to return cash collateral, or vice versa. An entity that

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establishes an accounting policy to offset the fair value amounts recognized for derivatives but concludes
that the amount recognized for the right to reclaim cash collateral or the obligation to return cash
collateral is not a fair value amount would still offset the derivatives.
ASC 815-10-45-7 explains that an entity that has established an accounting policy to offset fair value
amounts is not permitted to offset amounts recognized for the right to reclaim cash collateral or the
obligation to return cash collateral against net derivative positions in either of the following situations:
• The cash collateral amounts are not fair value amounts
• The cash collateral amounts arose from instruments in a master netting arrangement that are not
eligible to be offset
4.1.1.3 Special considerations for certain centrally cleared derivatives
Regulations that include the Dodd-Frank Wall Street Reform and Consumer Protection Act and the
European Market Infrastructure Regulation require certain over-the-counter derivatives to be centrally
cleared. Entities that enter into derivatives that are required to be centrally cleared typically make
variation margin payments to a margin account to provide credit risk protection to the other party to the
transaction. On a given day, the party to the derivative that is in a loss position will post payments to that
account, equal to that loss position, for the benefit of the other party. The margin account related to these
payments had historically been legally structured and documented as collateral by the clearing
exchanges and such contracts have been referred to as “collateralized to market” (CTM). In the 2016 and
2017 timeframe, two of the major exchanges, namely the Chicago Mercantile Exchange (CME) and LCH
Limited (LCH), began structuring certain contracts as settled to market (STM), and other exchanges have
followed suit. A change in the legal characterization of margin payments from collateral to settlement has
accounting and disclosure ramifications for impacted entities’ financial statements. On January 4, 2017,
the ISDA’s Accounting Policy Committee issued a confirmation letter to the Office of the Chief Accountant
of the SEC related to an ISDA whitepaper and follow-up submissions on the accounting impact of these
changes. Per the confirmation letter, it is the ISDA’s understanding that the SEC staff does not object to
the following conclusions:
• “The changes to the rulebooks of LCH and CME, as supported by legal opinions from external
counsel, should result in the presentation of variation margin amounts as settlement of the derivative
exposure and not collateral against it because the timing, amount, and uncertainty of cash flows
related to the STM derivative contract is considered a single unit-of-account for purposes of applying
the accounting and presentation guidance in ASC 815.
• The derivative disclosure requirements in ASC 815 would continue to apply for STM derivative
contracts given that STM derivative contracts remain term instruments and that daily settlement of the
derivative exposure does not change or reset the contractual terms of the instrument. Such
disclosures would be applicable over the remaining term of the STM derivative contract.
• The disclosure requirements in 815-10-50-4B(b), regarding cash collateral disclosures, should not be
applied to variation margin amounts for the STM derivative contracts.
• The de-designation and re-designation of existing hedging relationships under ASC 815 would not be
required solely because of the amendment described in the Submission to the respective CME and
LCH rulebooks.
• The daily settlement of the derivative exposure through daily payment or receipt of variation margin
amounts for the STM derivative contracts described in the Submission would not require a daily de-
designation and re-designation of hedging relationships under ASC 815.
• The inclusion of price alignment amount and variation margin in the single unit-of-account with the
derivative exposure would not prohibit application of the ‘short-cut method’ under ASC 815.”

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Given that STM derivative exposures are legally deemed to be settled such that the settlement payments
and related derivative are considered to be a single unit of account, we would expect the derivative
carrying amounts for STM transactions to be at or near zero. This will constitute a difference for reporting
entities that do not qualify or elect to net derivative carrying amounts with collateral on CTM transactions
as permitted by ASC 210-20.
4.1.2 Presentation on the statement of financial performance
If an entity holds derivatives for trading purposes, ASC 815-10-45-9 requires the gains and losses
(whether realized or unrealized) related to those derivatives to be shown net on the statement of financial
performance, regardless of whether they are settled physically. Reclassifications into and out of the
trading category should be rare.
In accordance with ASC 815-10-55-62, when determining whether realized gains and losses on physically
settled derivatives that are not held for trading purposes should be reported on the statement of financial
performance on a gross or net basis, an entity should use judgment and consider the relevant facts and
circumstances in the context of its various activities as well as the terms of the derivative contracts. An
entity may consider the derivative’s economic substance, as well as principal versus agent considerations
in ASC 606-10-55-36 through 55-40 and, if the arrangement involves the exchange of nonmonetary
assets, the guidance in ASC 845, Nonmonetary Transactions.
4.1.2.1 Presentation of the results of economic hedging
It’s generally not appropriate to recognize the earnings impact of a derivative that is used for economic
hedging purposes in multiple line items on the statement of financial performance. An example of this
would be an entity that enters into an interest rate swap to economically hedge its variable rate debt
(presentation for accounting hedges is discussed later in this section). It would not be appropriate for the
entity to report the change in fair value of the interest rate swap in a line item (e.g., other gain or loss)
different from where it reports the cash settlements on the interest rate swap (e.g., interest expense). This
is referred to as synthetic instrument accounting, which the FASB intended to eliminate with the issuance
of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and
Hedging Activities.
In Section II.M.3 of Current Accounting and Disclosure Issues in the Division of Corporate Finance as of
30 November 2006, the SEC indicated “We generally believe that a presentation that splits the
components of a derivative into different line items on the income statement or that reclassifies realized
gains and losses of a derivative out of the line item that included unrealized gains and losses of the same
derivative is inappropriate. For example, if a registrant classifies changes in fair value of economic
hedges (unrealized gains and losses) in a single line item such as “risk management activities”, a
registrant should not reclassify realized gains and losses (the periodic or final cash settlements from
these economic hedges) in the period realized out of risk management activities and into revenue or
expense lines associated with the related exposure.”
4.1.2.2 Employee and nonemployee stock options
Regarding options granted to employees and nonemployees in exchange for goods or services that are
required to be accounted for as a derivative, ASC 815-10-45-10 requires the change in the option award’s
fair value prior to vesting to be recognized as compensation expense in its statement of financial
performance. Once the option award vests, the grantor can recognize the change in the option award’s
fair value elsewhere (e.g., other gain or loss).
4.1.2.3 Hedging instruments
The following table summarizes the presentation of derivatives and other hedging instruments that have
been designated as the hedging instrument in each of the three types of accounting hedges discussed
below.

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Type of hedge Presentation in comprehensive income

Fair value hedge (ASC 815-25) • The carrying amount of the derivative or other hedging
instrument is adjusted to its fair value through earnings, with the
exception of amounts that are excluded from the assessment of
effectiveness and recognized in earnings through an
amortization approach. (Any difference between the change in
fair value of the excluded component and the initial value of the
excluded component recognized in earnings through an
amortization approach is recognized in OCI.)
• Amounts recognized in earnings for the derivative or other
hedging instrument are required to be presented in the same
line item in the statement of financial performance as the
earnings effect of the hedged item (the carrying amount of which
is adjusted for changes in its fair value that are attributable to
the hedged risk). This is illustrated in the examples in ASC 815-
20-55-79W through 55-79AD.
• As it relates to existing portfolio layer method hedges of interest
rate risk, upon the adoption of ASU 2022-01, ASC 815-20-45-
1CC requires the basis adjustment associated with the hedged
layer (or portion thereof) that is no longer outstanding when a
breach occurs to be presented in interest income.

Cash flow hedge (ASC 815-30) • All changes in the fair value of a derivative that are included in
the assessment of hedge effectiveness are recognized in OCI.
• Any components that are excluded from the assessment of
effectiveness are recognized in earnings (in the same line item
in the statement of financial performance as the effect of the
hedged item), either through an amortization or mark-to-market
approach.
• The gain or loss in OCI associated with amounts included in the
assessment of hedge effectiveness is reclassified into earnings
(in the same line item in the statements of financial performance
as the effect of the hedged item) in the same period or periods
during which the hedged forecasted transaction affects
earnings. (Refer to Section 6.2 of A guide to hedge accounting
upon the adoption of ASU 2017-12 for illustrations for certain
common types of hedged items.
• As noted in ASC 815-20-45-1B, ASC 815 does not proscribe the
classification in the statement of financial performance for
amounts that are reclassified out of AOCI and into earnings
because a hedged forecasted transaction is not probable.

Net investment hedge of a • All changes in the fair value of a derivative that are included in
foreign operation (ASC 815-35) the assessment of hedge effectiveness are recognized in OCI
as part of the cumulative translation adjustment.

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Type of hedge Presentation in comprehensive income

• If an election is made to assess effectiveness on an after-tax
basis, the portion of the gain or loss on the hedging instrument
in excess of the loss or gain on the hedged item is recognized
as an offset to the related tax effects when recognized.
• Any components that are excluded from the assessment of
effectiveness are recognized in earnings (ASC 815 does not
proscribe the line item in which this should be presented), either
through an amortization or mark-to-market approach. Any
difference between the change in fair value of the excluded
component and amounts recognized in earnings under a
systematic and rational method is also reported in the
cumulative translation adjustment section of OCI
• The gain or loss in OCI associated with amounts included in the
assessment of hedge effectiveness is reclassified into earnings
(in the same line item in the statement of financial performance
as the effect of the hedged item) in the same period or periods
during which the hedged forecasted transaction affects
earnings.

4.1.3 Presentation of hybrid instruments and a derivative that has been bifurcated from a host
contract
ASC 815-15-45-1 requires an entity to report hybrid financial instruments that are measured at fair value
in their entirety, under either the practicability exception or fair value election at ASC 815-15-30-1, “in a
manner that separates those reported fair values from the carrying amounts of assets and liabilities
subsequently measured using another measurement attribute on the face of the statement of financial
position.” This can be accomplished by either:
• Presenting hybrid financial instruments measured at fair value in separate line items from similar
instruments that do not have fair-value carrying amounts
• Presenting the aggregate of the hybrid financial instruments measured at fair value and similar
instruments that do not have fair-value carrying amounts on the same line item and
parenthetically disclose the amount of fair value carrying amounts included in the aggregate
amount.
ASC 815 does not specifically address the presentation of a derivative that has been bifurcated
(separated) from the host contract.
General practice and SEC preference is for bifurcated derivatives to be presented on the same statement
of financial position line item as the host contract if the host contract is classified as an asset or liability.
Thus, if, for example, a put option embedded in a debt instrument requires separate recognition as a
derivative, it would be appropriate to present the combined carrying amounts of the debt host and put
option derivative as debt, with separate footnote disclosure of the components, as required. If, however,
the host contract is reported in shareholders’ equity, it would not be possible to combine the host contract
and a separately recognized bifurcated derivative on the same line item in the statement of financial
position because the derivative is required to be recognized as an asset or liability, as opposed to
shareholders’ equity. As it relates to presentation on the statement of financial performance, an entity
should exercise judgment when determining whether it should report changes in the fair value of a
bifurcated derivative separate or apart from the activity associated with its host contract. An example of

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this would be considering if the changes in fair value of a derivative that is bifurcated from a debt host
contract should be classified in other income or loss or interest expense.
4.1.4 Presentation of derivative transactions on the statement of cash flows
A statement of cash flows classifies cash receipts and cash payments as resulting from operating,
investing or financing activities. ASC 815-10-45 indicates how a derivative that has an-other-than
insignificant financing element should be presented on the statement of cash flows.
Generally, under ASC 230, an entity classifies each cash receipt or payment according to its nature
without regard to whether it is intended as a hedge of another item. Cash flows from derivatives held for
trading purposes are generally presented within operating activities in accordance with ASC 230-10-45-
20. As an exception to classifying cash flows by their nature, ASC 230-10-45-27 permits cash flows from
derivatives that are accounted for as fair value hedges or cash flow hedges to be classified with the cash
flows from the item being hedged provided that the derivative does not include an other-than-insignificant
financing element at inception, other than a financing element inherently included in an at-the-market
derivative with no prepayments (such as the forward points in an at-the-money forward contract). For
example, cash flows pertaining to a fair value hedge utilizing a futures contract or an option contract to
hedge inventories would be reported with the cash flows related to inventories. If cash flows from a
derivative instrument are classified with the cash flows from the item being hedged, this represents an
accounting policy that should be disclosed. If hedge accounting is discontinued for any reason,
subsequent cash flows should be classified consistent with the nature of the derivative instrument rather
than with the cash flows from the item that was previously hedged.
As indicated in ASC 815-10-45-11, an instrument accounted for as a derivative that at its inception
includes off-market terms, and (or) requires an up-front cash payment, often contains a financing
element. Identifying such a financing element is a matter of judgment that depends on facts and
circumstances. If a derivative includes an other-than-insignificant financing element at inception, generally
all cash inflows and outflows of the derivative should be considered cash flows from financing activities by
the borrower. See ASC 230-10-45-14 and 45-15 for further guidance.

Example 4.1.2: Financing element considerations for specific instruments

At-the-money plain-vanilla interest rate swap (ASC 815-10-45-13)
An at-the-money plain-vanilla interest rate swap that involves no payments between the parties at
inception would not be considered as having a financing element present at inception even though,
due to the implicit forward rates derived from the yield curve, the parties to the contract have an
expectation that the comparison of the fixed and floating legs will result in payments being made by
one party in the earlier periods and being made by the counterparty in the later periods of the swap's
term.
At-the-money or out-of-the-money option contract (ASC 815-10-45-14 to 45-15)
If a derivative instrument is an at-the-money or out-of-the-money option contract or contains an at-
the-money or out-of-the-money option contract, a payment made at inception to the writer of the
option for the option's time value by the counterparty should not be viewed as evidence that the
derivative instrument contains a financing element. In contrast, if the contractual terms of a
derivative have been structured to ensure that net payments will be made by one party in the earlier
periods and subsequently returned by the counterparty in the later periods of the derivative's term,
that derivative instrument should be viewed as containing a financing element even if the derivative
has a fair value of zero at inception.

4.2 General disclosure requirements

Disclosures for derivatives, and in some cases their related hedging activity, are required in various notes
accompanying the financial statements, including:

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• Significant accounting policies (ASC 235-10-50)

• Derivatives (ASC 815-10-50)
• Disclosures on contracts in an entity’s own equity (ASC 815-40-50)
• Fair value measurements (ASC 820-10-50 and ASC 825-10-50)
• Balance sheet offsetting (ASC 210-20-50)
• Reporting comprehensive income (ASC 220-10-50)
Although this section focuses on the disclosure requirements of ASC 815-10-50 and ASC 815-30-50, the
other disclosures noted above are equally relevant and important and should not be overlooked.
Additionally, SEC reporting entities should consider any additional disclosures that may be required by
the SEC.
Significant accounting policies are required to be disclosed under ASC 235.
4.2.1 ASC 815-10 Disclosure requirements for derivatives and related hedging activities
ASC 815 requires extensive financial statement disclosures for derivatives and related hedging activity.
When an entity holds or issues derivatives, it is important that financial statement users can understand:
• How and why the entity uses derivatives
• How derivatives and related hedged items are accounted for
• How derivatives and related hedged items affect the entity’s financial position, financial performance
and cash flows as discussed in ASC 815-10-50-1
ASC 815 permits an entity to designate a nonderivative as a hedging instrument in certain situations. In
these cases, the disclosure requirements apply to the nonderivative hedging instrument in the same
manner that they apply to a derivative hedging instrument. Additionally, the derivative disclosure
requirements also apply to features within a hybrid instrument that require separate recognition as a
derivative.
If an entity presents any of the required derivative disclosures in more than a single footnote, it should
cross-reference from one footnote to the other as required by ASC 815-10-50-4I.
4.2.1.1 Qualitative disclosures: How and why the entity uses derivatives
In accordance with ASC 815-10-50-1A and 50-1B, an entity that holds or issues derivatives (or
nonderivative hedging instruments) must disclose the following in its annual and interim financial
statements.
• Its objectives for holding or issuing the derivative (or such nonderivative)
• The context needed to understand the above objectives
• Its strategies for achieving the above objectives
• Information that would allow the users of its financial statements to understand the volume of its
activity in those instruments, using the format and the specifics of disclosures that are most relevant
and practicable given the circumstances.
The first three of the four requirements should be disclosed in the context of each instrument’s primary
underlying risk exposure (e.g., interest rate, credit, foreign exchange rate, interest rate and foreign
exchange rate [i.e., cross-currency interest rate risk], or overall price).

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As explained in ASC 815-10-50-2, in these disclosures, an entity should distinguish between derivatives
(and nonderivative hedging instruments) used for risk management purposes and those used for other
purposes in the level of disaggregation displayed in the following graphic.

Derivative instruments (and nonderivative hedging instruments)

Used for
Used for risk management other
purposes

Used as economic
hedges and other
Designated as hedging instruments
purposes related to risk
exposures

Hedging
instruments
Fair value Cash flow
of a net
hedging hedging
investment in
instruments instruments
foreign
operation

As explained in ASC 815-10-50-5, qualitative disclosures about an entity’s objectives and strategies for
using derivatives (and nonderivative hedging instruments) may be more meaningful if the objectives and
strategies are described in the context of the entity’s overall risk exposures relating to interest rate risk,
foreign exchange risk, commodity price risk, credit risk and equity price risk and how they are managed.
While not required, if an entity makes these additional qualitative disclosures, it should include a
discussion of these exposures even if it does not manage some of these exposures by using derivatives.
ASC 815-10-50-4 requires the purpose of derivative activity to be disclosed for derivatives that are not
designated as hedging instruments.

Example 4.2.1: Objectives and strategies for using derivative instruments

This example illustrates the disclosure of objectives and strategies for using derivative instruments and
information about the volume of activity in those instruments.
Note X. Derivatives (in part)
Objectives and strategies for using derivatives: The Company is exposed to certain risks relating to
its ongoing business operations. The primary risks managed through derivative instruments are
commodity price risk and interest rate risk. All derivative instruments are recognized as either assets or
liabilities at fair value in the statement of financial position. The Company designates the derivatives
used to manage both commodity price risk and interest rate risk as cash flow hedges. As such, the gain
or loss on each derivative instrument is reported as a component of other comprehensive income and

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reclassified into earnings in the same line item in the statement of financial performance as the
earnings effect of the hedged item, and in the same period or periods during which the hedged
transaction affects earnings.
Cash flow hedges of commodity price risk: The Company manages its commodity price risk by
entering into forward contracts to hedge the risk of variability in cash flows attributable to changes in a
contractually specified component associated with forecasted fuel purchases. As of December 31,
20X2 and 20X1, the Company had forward contracts outstanding to purchase XXX and XXX gallons of
diesel fuel, respectively, over the course of the next 12 months.
Cash flow hedges of interest rate risk: The Company enters into interest rate swaps to manage the
interest rate risk associated with its variable rate debt. Specifically, the Company is hedging the risk of
variability in its cash flows attributable to changes in the contractually specified interest rate of three-
month LIBOR. As of December 31, 20X2 and 20X1, the Company had outstanding interest rate swaps
with combined notional amounts of $XXX and $XXX, respectively, that mature through various dates in
20X6. While the notional amount does not exchange hands, each quarter during the terms of the
swaps, the Company pays the counterparty payments based on a fixed rate and receives payments
based on the current three-month LIBOR rate, with both rates applied to the notional amount.

4.2.1.2 Overall quantitative disclosures

ASC 815 contains extensive quantitative disclosure requirements regarding the location and fair value
amounts of derivatives and their associated gains and losses recognized in the financial statements. As
noted in ASC 815-10-50-4E, these disclosures are required to be in tabular format. They are also largely
required to be segregated based on whether the derivatives are designated as hedging instruments and
by type of contract, with the following contract types specifically listed as examples in ASC 815-10-50-4D:

Derivatives and nonderivative

Derivatives not designated as hedging
instruments designated as hedging
instruments
instruments
Interest rate contracts Interest rate contracts
Foreign exchange contracts Foreign exchange contracts
Equity contracts Equity contracts
Commodity contracts Commodity contracts
Credit contracts Credit contracts
Other contracts Other contracts

Example 21 in ASC 815-10-55 provides an illustration of a tabular disclosure for the requirements in ASC
815-10-50-4A through 50-4E. While not required, ASC 815-10-50-5A explains that quantitative
disclosures about derivatives may be more useful, and less likely to be perceived to be out of context or
misunderstood, if the entity discloses similar information by activity about related financial instruments or
nonfinancial assets and liabilities. Examples may include disclosing similar information for:
• Servicing assets and liabilities and the derivatives used to mitigate the earnings volatility risk they
pose
• Mortgage loans held for sale and related loan commitments and the derivatives used to mitigate the
earnings volatility risk they pose

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As indicated in ASC 815-10-50-4A and 50-4B, an entity that holds or issues derivatives (and/or
nonderivative hedging instruments) should disclose the following for each annual and interim reporting
period for which it presents a statement of financial position and statement of financial performance:
a. The location (line item) and fair value amounts of derivatives and nonderivative hedging instruments
reported on the statement of financial position in accordance with the following requirements:
i. Fair value amounts should be presented on a gross basis even if the instruments qualify for net
presentation on the statement of financial position.
ii. Cash collateral should not be added to or netted against the fair value amounts.
iii. The fair value asset and liability amounts should be segregated between: (a) derivative and
nonderivative hedging instruments, presented separately by contract type (e.g., interest rate
contracts, foreign exchange contracts, etc.) and (b) derivative instruments not designated as
hedging instruments, presented separately by contract type.
iv. A nonderivative hedging instrument that may give rise to a foreign currency gain or loss should be
reported at its carrying amount, inclusive of its foreign currency transaction gain or loss.
v. Private companies that elect and qualify to use the settlement value in place of fair value under
the simplified hedge accounting approach described beginning at ASC 815-20-25-133 should
clearly state that the carrying amount is settlement value and disclose it separately from amounts
disclosed at fair value.

Example 4.2.2: Sample portion of footnote illustrating only the tabular disclosure of fair
values of derivative instruments in a statement of financial position –
adapted from ASC 815-10-55-182
Note X. Derivatives (in part)

Fair Values of Derivative Instruments

(in millions of dollars)

Derivative Assets

December 31, 20X0 December 31, 20X9

Balance Balance
Sheet Fair Sheet Fair
Location Value Location Value

Derivatives designated as
hedging instruments

Interest rate contracts Other assets $ XX,XXX Other assets $ XX,XXX

Foreign exchange contracts Other assets XX,XXX Other assets XX,XXX

Commodity contracts Other assets XX,XXX Other assets XX,XXX

Credit contracts Other assets XX,XXX Other assets XX,XXX

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Other contracts Other assets XX,XXX Other assets XX,XXX

Total derivatives designated

as hedging instruments
$ XX,XXX $ XX,XXX

Derivatives not designated

as hedging instruments

Interest rate contracts Other assets $ XX,XXX Other assets $ XX,XXX

Foreign exchange contracts Other assets XX,XXX Other assets XX,XXX

Equity contracts Other assets XX,XXX Other assets XX,XXX

Commodity contracts Other assets XX,XXX Other assets XX,XXX

Credit contracts Other assets XX,XXX Other assets XX,XXX

Other contracts Other assets XX,XXX Other assets XX,XXX

Total derivatives not

designated as hedging
instruments XX,XXX XX,XXX

Total derivative assets $ XX,XXX $ XX,XXX

Derivative Liabilities

December 31, 20X0 December 31, 20X9

Balance Balance
Sheet Fair Sheet Fair
Location Value Location Value

Derivatives designated as
hedging instruments

Other Other
Interest rate contracts liabilities $ XX,XXX liabilities $ XX,XXX

Other Other
Foreign exchange contracts liabilities XX,XXX liabilities XX,XXX

Other Other
Commodity contracts liabilities XX,XXX liabilities XX,XXX

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Other Other
Credit contracts liabilities XX,XXX liabilities XX,XXX

Other Other
Other contracts liabilities XX,XXX liabilities XX,XXX

Total derivatives designated

as hedging instruments
$ XX,XXX $ XX,XXX

Derivatives not designated as

hedging instruments

Other Other
Interest rate contracts liabilities $ XX,XXX liabilities $ XX,XXX

Other Other
Foreign exchange contracts liabilities XX,XXX liabilities XX,XXX

Other Other
Equity contracts liabilities XX,XXX liabilities XX,XXX

Other Other
Commodity contracts liabilities XX,XXX liabilities XX,XXX

Other Other
Credit contracts liabilities XX,XXX liabilities XX,XXX

Other Other
Other contracts liabilities XX,XXX liabilities XX,XXX

Total derivatives not

designated as hedging
instruments XX,XXX XX,XXX

Total derivative liabilities $ XX,XXX $ XX,XXX

b. The location (line item) and amount of the gains and losses reported on the statement of financial
performance and the statement of financial position (e.g., gains and losses initially recognized in OCI)
on derivatives (and nonderivative hedging instruments) and related hedged items. This disclosure is
required to be presented by type of contract.
Additionally, in accordance with ASC 815-10-50-4C, gains and losses for qualifying fair value and
cash flow hedges must also be presented separately by income and expense line item for:
i. Derivatives (and nonderivative hedging instruments) in fair value hedges and related hedged
items

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ii. The gains and losses on cash flow hedging derivatives that were included in the effectiveness
assessment and recognized in OCI during the current period
iii. Amounts excluded from the effectiveness assessment that were recognized in OCI during the
period for which an amortization approach is applied under ASC 815-20-25-83A
iv. The gains and losses on cash flow hedging derivatives that were included in the effectiveness
assessment and recorded in accumulated OCI (AOCI) during the hedging relationship and
reclassified into earnings during the current period
v. The portion of gains and losses on fair value hedging derivatives and cash flow hedging
derivatives representing the amount (if any) excluded from the effectiveness assessment that is
recognized in earnings, broken out by (1) amounts recognized in earnings through an
amortization approach and (2) amounts recognized through changes in fair value in earnings
Note that ASC 815-10-50-4EEEE requires an entity to disclose in its summary of significant
accounting policies its election to record changes in the fair value of amounts excluded from the
effectiveness assessment currently in earnings.
vi. The gains and losses reclassified into earnings as a result of discontinuing cash flow hedges
because it is probable that the original hedged forecasted transactions will not occur by the end of
the originally specified or additional time periods discussed at ASC 815-30-40-4 through 40-5.
vii. The amount of net gain or loss recognized in earnings when a hedged firm commitment no longer
qualifies as a fair value hedge.
c. The total amount of each income and expense line item presented on the statement of financial
performance where the results of fair value or cash flow hedges are recorded.

Spotlight on frequently overlooked disclosure requirement

The requirement to disclose the total amount of each income or expense line item presented on the
statement of financial performance where the results of fair value or cash flow hedges are recorded is
frequently overlooked. This is the top line item on the example disclosure that follows for The Effect of
Fair Value and Cash Flow Hedge Accounting On The Statement Of Financial Performance.

ASC 815-10-50-4CCC explains that the gains and losses from hedging instruments in net investment
hedges must be presented separately for all the following by type of contract:
a. The gains and losses on derivative instruments (and nonderivative instruments) designated and
qualifying in net investment hedges that were recognized in the cumulative translation adjustment
section of other comprehensive income during the current period
b. The gains and losses on derivative instruments (and nonderivative instruments) designated and
qualifying in net investment hedges recorded in the cumulative translation adjustment section of
accumulated other comprehensive income during the term of the hedging relationship and
reclassified into earnings during the current period
c. The portion of gains and losses on derivative instruments (and nonderivative instruments)
designated and qualifying in net investment hedges representing the amount, if any, excluded
from the assessment of hedge effectiveness.
As indicated in ASC 815-10-50-4E, if a proportion of a derivative is designated as a hedging instrument
and a proportion is not so designated, an entity should allocate the related amounts to the proper
categories within the disclosure tables.

Example 4.2.3: Sample portion of footnote illustrating only the tabular disclosure of gains and
losses from derivative instruments reported on the statement of financial

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performance and the statement of financial position in a statement of financial

position – adapted from ASC 815-10-55-182

The Effect of Fair Value and Cash Flow Hedge Accounting on Accumulated Other
Comprehensive Income for the Years Ended December 31, 20X0 and 20X9

Amount of Gain or (Loss)

Amount of Gain or (Loss) Reclassified from
Recognized in Other Location of Gain or Accumulated Other
Derivatives in Comprehensive Income on (Loss) Reclassified Comprehensive Income
Subtopic 815-20 Derivative from Accumulated into Income
Hedging Other Comprehensive
Relationships 2010 2009 Income into Income(a) 2010 2009

Derivatives in Cash Flow Hedging Relationships

Interest rate Interest

contracts $ XX,XXX $ XX,XXX income/(expense) $ XX,XXX $ XX,XXX

Foreign exchange
contracts XX,XXX XX,XXX Sales/Revenue XX,XXX XX,XXX

Commodity
contracts XX,XXX XX,XXX Cost of sales XX,XXX XX,XXX

Other
Credit derivatives XX,XXX XX,XXX income/(expense) XX,XXX XX,XXX

Other
Other contracts XX,XXX XX,XXX income/(expense) XX,XXX XX,XXX

Total $ XX,XXX $ XX,XXX $ XX,XXX $ XX,XXX

Derivatives in Cash Flow Hedging Relationships(b)

Interest rate
contracts $ XX,XXX $ XX,XXX

Foreign exchange
contracts XX,XXX XX,XXX

Commodity
contracts XX,XXX XX,XXX

Credit derivatives XX,XXX XX,XXX

Other contracts XX,XXX XX,XXX

Total $ XX,XXX $ XX,XXX

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(a)If gains and losses associated with a type of contract (for example, interest rate contracts) are
displayed in multiple line items in the statement of financial performance, the entity is required to
disclose the amount included in each line item.
Represents amounts excluded from the assessment of effectiveness for which the difference
(b)

between changes in fair value and periodic amortization is recorded in other comprehensive income.

The Effect of Fair Value and Cash Flow Hedge Accounting on the Statement of Financial
Performance for the Years Ended December 20X1 and 20X0

Location and Amount of Gain or (Loss) Recognized in Income on Fair Value and Cash
Flow Hedging Relationships(a)

20X1 20X0

Cost of Interest Other Cost of Interest Other

Goods Income Income Goods Income Income
Revenue Sold (Expense) (Expense) Revenue Sold (Expense) (Expense)

Total amounts of income

and expense line items
presented in the statement
of financial performance in
which the effects of fair
value or cash flow hedges
are recorded $ XX,XXX $ XX,XXX $ XX,XXX $ XX,XXX $ XX,XXX $ XX,XXX $ XX,XXX $ XX,XXX

The effects of fair value and

cash flow hedging:

Gain or (loss) on fair

value hedging
relationships in
Subtopic 815-20:

Interest contracts:

Hedged items XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Derivatives
designated as
hedging instruments XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Commodity contracts:

Hedged items XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

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Derivatives
designated as
hedging instruments XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Amount excluded
from effectiveness
testing recognized in
earnings based on an
amortization approach XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Foreign exchange
contracts:

Hedged items XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Derivatives
designated as
hedging instruments XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Amount excluded
from effectiveness
testing recognized in
earnings based on an
amortization approach XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Credit contracts:

Hedged items XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Derivatives
designated as
hedging instruments XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Amount excluded
from effectiveness
testing recognized in
earnings based on an
amortization approach XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Gain or (loss) on cash

flow hedging
relationships in
Subtopic 815-20:

Interest contracts:

Amount of gain or
(loss) reclassified
XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX
from accumulated

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other comprehensive
income into income

Amount of gain or
(loss) reclassified
from accumulated
other comprehensive
income into income
as a result that a
forecasted transaction
is probable of not
occurring XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Commodity contracts:

Amount of gain or
(loss) reclassified
from accumulated
other comprehensive
income into income XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Amount excluded
from effectiveness
testing recognized in
earnings based on
changes in fair value XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Foreign exchange
contracts:

Amount of gain or
(loss) reclassified
from accumulated
other comprehensive
income into income XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Amount excluded
from effectiveness
testing recognized in
earnings based on
changes in fair value XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

Credit contracts:

Amount of gain or
(loss) reclassified
from accumulated
other comprehensive
income into income XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

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Amount excluded
from effectiveness
testing recognized in
earnings based on
changes in fair value XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX XX,XXX

(a)If gains and losses associated with a type of contract (for example, interest rate contracts) are
displayed in multiple line items in the statement of financial performance, the entity is required to disclose
the amount included in each line item.

Effect of Net Investment Hedges on Accumulated Other Comprehensive Income

and the Statement of Financial Performance

Amount of Gain or (Loss) Recognized in Other

Derivatives in Subtopic 815- Comprehensive Income on Derivative
20 Net Investment Hedging
Relationships 2010 2009

Foreign exchange contracts $ XX,XXX $ XX,XXX

Location of Gain or (Loss) Amount of Gain or (Loss) Reclassified from

Reclassified from Accumulated Other Comprehensive Income into
Accumulated Other Income
Comprehensive Income into
Income(a) 2010 2009

Gain or (loss) on sale of

subsidiary $ XX,XXX $ XX,XXX

Amount of Gain or (Loss) Recognized in Income

Location of Gain or (Loss) on Derivative (Amount Excluded from
Recognized in Income on Effectiveness Testing)
Derivative (Amount Excluded
from Effectiveness Testing)(a) 2010 2009

Other income/(expense) $ XX,XXX $ XX,XXX

If gains and losses associated with a type of contract (for example, interest rate contracts)
(a)

are displayed in multiple line items in the statement of financial performance, the entity is
required to disclose the amount included in each line item.

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Effect on Derivatives Not Designated as Hedging Instruments on the Statement of

Financial Performance

Amount of Gain or (Loss)

Derivatives Not Recognized in Income on
Designated as Hedging Location of Gain or (Loss) Derivative
Instruments under Recognized in Income on
Subtopic 815-20(b)(c) Derivative(a) 20X0 20X9

Interest rate contracts Other income/(expense) $ XX,XXX $ XX,XXX

Foreign exchange
contracts Other income/(expense) XX,XXX XX,XXX

Equity contracts Other income/(expense) XX,XXX XX,XXX

Commodity contracts Other income/(expense) XX,XXX XX,XXX

Credit derivatives Other income/(expense) XX,XXX XX,XXX

Other contracts Other income/(expense) XX,XXX XX,XXX

Total $ XX,XXX $ XX,XXX

(a)If gains and losses associated with a type of contract (for example, interest rate contracts) are
displayed in multiple line items in the statement of financial performance, the entity is required to disclose
the amount included in each line item.
(b)See note XX for additional information on the ABC Entity’s purpose for entering into derivative
instruments not designated as hedging instruments and its overall risk management strategies.
(c)For alternative disclosures about “trading derivatives,” see separate table for trading activities in notes
to financial statements.
(d) Footnote superseded by Accounting Standards Update No. 2017-12.

ASC 815-10-50-4EE requires the following tabular disclosure for hedged items in fair value hedges.
a. The carrying amount of hedged assets and liabilities recognized on the statement of financial
position. For an available-for-sale debt security, the amount disclosed is the amortized cost basis.
b. The cumulative amount of fair value hedging adjustments to hedged assets and liabilities included
in the carrying amount of the hedged assets and liabilities recognized on the statement of
financial position.
c. The line item in the statement of financial position that includes the hedged assets and liabilities.
d. The cumulative amount of fair value hedging adjustments remaining for any hedged assets and
liabilities for which hedge accounting has been discontinued.
The disclosures required by (b) and (d) shall exclude cumulative basis adjustments related to foreign
exchange risk.

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4.2.1.2.1 Example tabular disclosure for hedged items in fair value hedges

Example 4.2.4: Example tabular disclosure for hedged items in fair value hedges – adapted from
ASC 815-10-55-181
Fair value hedges
For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the
derivative instrument as well as the offsetting loss or gain on the hedged item attributable to the
hedged risk are recognized in current earnings. The Entity includes the gain or loss on the hedged
items (that is, fixed-rate receivables) in the same line item—interest income—as the offsetting loss or
gain on the related interest rate swaps.
As of December 31, 20X2 and 20X1, the following amounts were recorded on the balance sheet
related to cumulative basis adjustments for fair value hedges.

Cumulative Amount of Fair

Value Hedging Adjustment
Line Item in the Included in the Carrying
Statement of Carrying Amount of the Hedged Amount of the Hedged
Financial Position in Assets/(Liabilities) Assets/(Liabilities)
Which the Hedged
Item Is Included 20X2 20X1 20X2 20X1

Loans receivable(a) $115 $124 $10(b) $20

These amounts include the amortized costs basis of closed portfolios used to designate hedging relationships in which
(a)

the hedged time is the last layer expected to be remaining at the end of the hedging relationship. At December 31, 20X2
and 20X1, the amortized cost basis of the closed portfolios used in these hedging relationships was $52 and $60,
respectively, the cumulative basis adjustments associated with these hedging relationships was $5 and $7, respectively,
and the amounts of the designated hedged items were $16 and $18, respectively.
(b) The balance includes $2 of hedging adjustment on a discontinued hedging relationship.

As of December 31, 20X2 and 20X1, the total notational amount of the Entity’s pay-fixed/receive-
variable interest rate swaps was $79 and $82, respectively.

In accordance with ASC 815-10-50-4EEE, for each line item disclosed in accordance with (c) in the
preceding paragraph that includes hedging relationships designated under the last-of-layer or portfolio
layer method, an entity should separately disclose:
a. The amortized cost basis of the closed portfolio(s) of financial assets or the beneficial interest(s)
b. The amount that represents the hedged item(s) (that is, the hedged layer or layers)
c. The basis adjustment associated with the hedged item(s) (that is, the hedged layer or layers).
Example 20 (see paragraph 815-10-55-181) illustrates these disclosures.
4.2.1.2.2 Trading derivatives
The preceding comprehensive derivative disclosure in Section 4.2.1.2 of this chapter included a
disclosure for the effect of derivatives not designated as hedging instruments on the statement of financial
performance. ASC 815-10-50-4F and ASC 815-10-55-183 explain that if an entity’s policy is to include
derivatives that are not designated as hedging instruments in its trading activities, it can elect to not
separately disclose gains and losses in this tabular format but rather disclose the gains and losses on
derivatives with its other trading activities provided that the following are disclosed.

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a. The gains and losses on its trading activities (including both derivative and nonderivative instruments)
recognized on the statement of financial performance, separately by major types of items, for
example:
1. Fixed income/interest rates
2. Foreign exchange
3. Equity
4. Commodity
5. Credit
b. The line items on the statement of financial performance in which trading activities gains and losses
are included
c. A description of the nature of its trading activities and related risks, and how the entity manages those
risks
If an entity elects to include this information about its derivative trading activities outside the derivative
footnote, it should cross-reference the derivative footnote to the footnote in which it is included. An
example of a disclosure that includes gains on losses on derivatives with other trading activities follows:

Example 4.2.5: Sample portion of footnote illustrating only the tabular disclosure of trading
derivatives – ASC 815-10-55-184

Note X. Derivatives (in part)

The Effect of Trading Activities on the Statement of Financial

Performance for the Years Ended December 31, 20X0 and 20X9

Trading Revenue

Types of Instrument 20X0 20X9

Fixed income/interest rate $ XX,XXX $ XX,XXX

Foreign exchange XX,XXX XX,XXX

Equity XX,XXX XX,XXX

Commodity XX,XXX XX,XXX

Credit XX,XXX XX,XXX

Other XX,XXX XX,XXX

Total $ XX,XXX $ XX,XXX

Line Item in Statement of Financial Performance Trading Revenue

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20X0 20X9

Principal/Proprietary transactions $ XX,XXX $ XX,XXX

Asset management income XX,XXX XX,XXX

Other income XX,XXX XX,XXX

Total $ XX,XXX $ XX,XXX

The revenue related to each category includes realized and unrealized gains and losses on both
derivative instruments and nonderivative instruments.

4.2.1.3 Basis adjustment considerations under the last-of-layer or portfolio layer method
ASC 815-20-25-12A allows an approach to fair value hedges referred to as the last-of-layer method (prior
to the adoption of ASU 2022-01), or the portfolio layer method (after the adoption of ASU 2022-01). Under
these methods, an entity is allowed to designate a closed portfolio of qualifying financial assets or
beneficial interests as the hedged item in a fair value hedge of interest rate risk if certain criteria are met.
ASC 815-10-50-5B provides guidance on how the basis adjustments that are made to the hedged item
through the application of fair value hedge accounting should be considered when meeting the non-ASC
815 disclosure requirements that are relevant to the assets within the closed portfolio (e.g., the
requirements of ASC 310, ASC 320 and ASC 326). Additionally, upon the adoption of ASU 2022-01, ASC
815-10-50-5C requires certain disclosures if the outstanding amount of the closed portfolio that is
designated as the hedged item is less than the hedged layer or layers (i.e., a breach has occurred).
Namely, the amount of the hedge basis adjustment that is recognized in current-period interest income
because of the breach as well as the circumstances that led to the breach should be disclosed.
4.2.1.4 Credit-risk-related contingent features
To alert the financial statement users to potential cash flow issues that may result from using derivatives,
an entity is required to disclose certain information regarding counterparty credit risk and the existence of
credit-risk-related contingent features. A common example of such a feature is a requirement to post
additional collateral if certain events occur such as a downgrade in credit rating. Pursuant to ASC 815-10-
50-4H, an entity that holds or issues derivatives (or nonderivative hedging instruments) should disclose
the following for every annual and interim reporting period for which a statement of financial position is
presented:
a. The existence and nature of credit-risk-related contingent features and the circumstances in which
these features could be triggered in derivatives (or nonderivative hedging instruments) that are in a
net liability position at the end of the reporting period
b. The aggregate fair value amounts of derivatives (or nonderivative hedging instruments) that contain
credit-risk-related contingent features that are in a net liability position at the end of the reporting
period
c. The aggregate fair value of assets that are already posted as collateral at the end of the reporting
period and the aggregate fair value of additional assets that would be required to be posted as
collateral and/or needed to settle the instrument immediately, if the credit-risk-related contingent
features were triggered at the end of the reporting period

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Amounts required to be reported for nonderivative hedging instruments should be the carrying value of
the nonderivative hedging instrument, which includes the adjustment for the foreign currency transaction
gain or loss on that instrument.

Example 4.2.6: Sample portion of footnote illustrating only the disclosure of contingent features in
derivative instruments – ASC 815-10-55-185
Note X. Derivatives (in part)
Contingent features: Certain of the Entity’s derivative instruments contain provisions that require the
Entity’s debt to maintain an investment-grade credit rating from each of the major credit-rating agencies. If
the Company’s debt were to fall below investment grade, it would be in violation of these provisions, and
the counterparties to the derivative instruments could request immediate payment or demand immediate
and ongoing full overnight collateralization on derivative instruments in net liability positions. The
aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a
liability position on December 31, 20X9, is $XX million, for which the Company has posted collateral of $X
million in the normal course of business. If the credit-risk-related contingent features underlying these
agreements were triggered on December 31, 20X9, the Company would be required to post an additional
$XX million of collateral to its counterparties.

4.2.1.5 Credit derivatives

A credit derivative is a derivative (a) in which one or more of its underlyings are related to the credit risk of
a specified entity (or a group of entities) or an index based on the credit risk of a group of entities and (b)
that exposes the seller to potential loss from credit-risk-related events specified in the contract. Examples
of credit derivatives include, but are not limited to, credit default swaps, credit spread options and credit
index products.
A seller of credit derivatives (sometimes referred to as the writer of the contract) is the party that assumes
credit risk, which could be a guarantor in a guarantee-type contract, or any party that provides the credit
protection in a credit derivative contract.
As noted in ASC 815-10-50-4K, a seller of credit derivatives should disclose information about its credit
derivatives and hybrid instruments (e.g., credit-linked notes) that have embedded credit derivatives to
allow financial statement users to assess the potential effect of these derivatives and hybrid instruments
on the entity’s financial statements. With respect to hybrid instruments that have embedded credit
derivatives, the seller of the embedded credit derivative should disclose the required information for the
entire hybrid instrument, not just the embedded credit derivatives. However, these disclosures do not
apply to an embedded derivative related to the transfer of credit risk that is only in the form of
subordination of one financial instrument to another.
Even if there only is a remote chance that the seller of a credit derivative would be required to make any
payments under that derivative, ASC 815-10-50-4K requires that for each statement of financial position
presented, the seller should disclose the following information for each credit derivative (or each group of
similar credit derivatives):
a. The nature of the credit derivative, including all of the following:
1. The approximate term of the credit derivative
2. The reason(s) for entering into the credit derivative
3. The events or circumstances that would require the seller to perform under the credit
derivative
4. The current status (that is, as of the date of the statement of financial position) of the
payment/performance risk of the credit derivative, which could be based on either recently
issued external credit ratings or current internal groupings used by the seller to manage its risk

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5. If the entity uses internal groupings for purposes of item (a)(4), how those groupings are
determined and used for managing risk.
b. All of the following information about the maximum potential amount of future payments under the
credit derivative:
1. The maximum potential amount of future payments (undiscounted) that the seller could be
required to make under the credit derivative, which shall not be reduced by the effect of any
amounts that may possibly be recovered under recourse or collateralization provisions in the
credit derivative (which are addressed in items (c) through (f))
2. The fact that the terms of the credit derivative provide for no limitation to the maximum
potential future payments under the contract, if applicable
3. If the seller is unable to develop an estimate of the maximum potential amount of future
payments under the credit derivative, the reasons why it cannot estimate the maximum
potential amount.
c. The fair value of the credit derivative as of the date of the statement of financial position
d. The nature of any recourse provisions that would enable the seller to recover from third parties
any of the amounts paid under the credit derivative
e. The nature of any assets held either as collateral or by third parties that, upon the occurrence of
any specified triggering event or condition under the credit derivative, the seller can obtain and
liquidate to recover all or a portion of the amounts paid under the credit derivative
f. If estimable, the approximate extent to which the proceeds from liquidation of assets held either as
collateral or by third parties would be expected to cover the maximum potential amount of future
payments under the credit derivative. In its estimate of potential recoveries, the seller of credit
protection shall consider the effect of any purchased credit protection with identical underlying(s).
One way to present the above information for groups of similar credit derivatives is provided in ASC 815-
10-50-4L. That is, an entity would first segregate the disclosures by major types of contracts. Examples of
major types of contracts include, but are not limited to:
• Single-name credit default swaps
• Traded indexes
• Other portfolio products
• Swaptions
Then, for each major type, an entity may provide additional subgroups for major types of
referenced/underlying asset classes (e.g., corporate debt, sovereign debt, and structured finance).
4.2.1.6 Additional disclosures for cash flow hedges
In addition to the disclosures above, ASC 815-30-50-1 requires the following disclosures in annual and
interim financial statements for cash flow hedging instruments and the transactions they hedge:
a. A description of the transactions or other events that will result in the reclassification into earnings of
gains and losses that are reported in AOCI
b. The estimated net amount of the existing gains or losses at the reporting date that is expected to be
reclassified into earnings within the next 12 months (according to ASC 815-30-50-4 could be different
than the net amount reported in AOCI)
c. The maximum length of time over which the entity is hedging its exposure to the variability in future
cash flows for forecasted transactions excluding those forecasted transactions related to the payment
of variable interest on existing financial instruments
As noted in ASC 815-30-50-4 through 50-6, the amount of OCI to be reclassified into earnings in the
coming 12 months could be greater or less than the net amount reported in AOCI. If there are multiple

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cash flows associated with the hedged transaction, the amount in AOCI needs to be allocated to each of
the forecasted transactions. Consideration generally needs to be given to the underlying fair value and
expected cash flow computations for the derivative amounts to which the AOCI balance relates. To
illustrate using the swap example in Section 4.1.1.1 of this chapter, the swap is in an asset position and
has a fair value of $10 million recorded in OCI that is comprised of gross expected cash outflows with a
net present value of approximately $3 million in the next 12 months, and gross expected cash inflows with
a net present value of approximately $13 million for the remaining term of the interest rate swap.

Example 4.2.7: Reclassification of AOCI to earnings over the next 12 months

The gain or loss on our interest rate swap is reported as a component of OCI and reclassified into
earnings in the same period or periods during which the hedged transaction affects earnings. As of
December 31, 20X0, $3 million of the amount deferred in AOCI is expected to be reclassified to
earnings as an increase to interest expense during the next twelve months.

ASC 220-10-45-14A requires changes in AOCI to be presented either on the face of the financial
statements or as a separate disclosure in the notes. Various illustrative examples are included in ASC
220-10-55. The following details are required to be disclosed by ASC 815-30-50-2:
a. The beginning and ending accumulated derivative instrument gain or loss
b. The related net change associated with current period hedging transactions
c. The net amount of any reclassification into earnings
d. The difference between the change in fair value of an excluded component and the initial value of
that excluded component recognized in earnings under a systematic and rational method in
accordance with paragraph 815-20-25-83A.
4.2.1.7 Additional disclosures for embedded derivatives that are not separated
In addition to the required disclosures discussed above, ASC 815-15-50-1 explains that if an entity
accounts for hybrid financial instruments at fair value, it should also disclose the information required by
ASC 825-10-50-28 to 32 for the fair value option.
Further, ASC 815-15-50-2 requires an entity to provide information that will allow financial statement
users to understand the effect of changes in the fair value of hybrid financial instruments measured at fair
value on earnings (or other performance indicators for an entity that does not report earnings).
As it relates to a convertible instrument such as debt for which an embedded conversion option previously
accounted for as a derivative no longer meets the separation criteria, the entity is required to disclose
both of the following pursuant to ASC 815-15-50-3:
a. A description of the principal changes causing the embedded conversion option to no longer require
bifurcation under this subtopic
b. The amount of the liability for the conversion option reclassified to stockholders' equity
4.2.1.8 Disclosures regarding statement of financial position offsetting
ASC 815-10-50-7 requires an entity to disclose its accounting policy as to whether it offsets or does not
offset assets and liabilities with the same counterparty. ASC 815-10-50-7A reinforces the fact that ASC
210-20-50 requires disclosures about derivatives that are either offset or subject to an enforceable master
netting arrangement or similar agreement as discussed in Section 4.1.1.2 of this chapter. These
requirements are outlined in ASC 210-20-50-1 to 50-6.
For such derivatives, an entity is required to disclose information that enables financial statement users to
evaluate the effect or potential effect of netting arrangements on its financial position for recognized
assets and liabilities. These disclosures are important in building comparability between entities that elect

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to offset qualifying amounts and those that do not. These requirements are illustrated through the use of
various examples included in ASC 210-20-55.
ASC 815-10-50-8 requires an entity to disclose the amounts recognized at the end of each reporting
period for the right to reclaim cash collateral or the obligation to return it as follows:
a. A reporting entity that has made an accounting policy to offset fair value amounts shall separately
disclose amounts recognized for the right to reclaim cash collateral or the obligation to return
cash collateral that have been offset against net derivative positions in accordance with
paragraph 815-10-45-5.
b. A reporting entity shall separately disclose amounts recognized for the right to reclaim cash
collateral or the obligation to return cash collateral under master netting arrangements that have
not been offset against net derivative positions.
c. A reporting entity that has made an accounting policy to not offset fair value amounts shall
separately disclose recognized for the right to reclaim cash collateral or the obligation to return
cash collateral under master netting arrangements.
4.2.1.9 Additional disclosures for contracts in an entity’s own equity
ASC 815-40, Contracts in Entity’s Own Equity, applies to not only certain derivatives that are indexed to,
and potentially settled in, an entity’s own stock but also to certain derivative-like instruments. Its
disclosure requirements should be considered by entities that have contracts on their own equity
outstanding. Refer to Chapter 5 of Accounting for debt and equity instruments in financing transactions for
additional information on ASC 815-40.
4.2.1.10 Disclosures by not-for-profit organizations
As indicated in ASC 815-10-50-4G, not-for-profit organizations (NFPs) within the scope of ASC 954,
Health Care Entities, should present quantitative disclosure tables that are similarly formatted to those
discussed herein. NFPs should refer to amounts within their performance indicator, instead of in earnings,
and amounts outside their performance indicator, instead of in OCI. Other NFPs should disclose the gain
or loss recognized in changes in net assets using a similar format. All NFPs also should indicate which
class or classes of net assets (unrestricted, temporarily restricted or permanently restricted) are affected.

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Appendix A: Accounting Standards Updates mentioned in this guide

A.1 ASU 2018-12
A.1.1 Overview
This ASU makes the following targeted improvements to the existing recognition, measurement,
presentation and disclosure requirements regarding long-duration contracts that are issued by an
insurance entity. The amendments set forth in the ASU aim to:
• Improve the timeliness of recognizing changes in the liability for future policy benefits and modify the
rate used to discount future cash flows
• Simplify and improve the accounting for certain market-based options or guarantees associated with
deposit (or account balance) contracts
• Simplify the amortization of deferred acquisition costs
• Improve the effectiveness of the required disclosures
A.1.1 Effective date and transition considerations
For public business entities, ASU 2018-12 is effective for fiscal years beginning after December 15, 2020,
and interim periods within those fiscal years,. For all other entities, this ASU is effective for fiscal years
beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15,
2022. Early application of the ASU is permitted.
Any change to liabilities for future policy benefits and deferred acquisitions costs should be applied to
outstanding contracts based on their carrying amounts at the beginning of the earliest period presented,
subject to certain adjustments. Insurance entities will be able to choose to apply the amendments
retrospectively using actual historical information as of contract inception. Entities will measure market
risk benefits at fair value at the beginning of the earliest period presented and will recognize the
cumulative effect of the changes in the entity’s credit risk in AOCI with the difference between a contract’s
fair value and carrying value (other than the effect of changes in credit risk) recognized in the opening
balance of retained earnings.
A.2 ASU 2022-01
A.2.1 Overview
Before the FASB issued ASU 2017- 12, entities found it difficult to achieve fair value hedge accounting for
closed portfolios of prepayable financial assets for interest rate risk. ASU 2017-12 created the “last-of-
layer” method, which makes hedge accounting for closed portfolios of prepayable financial assets more
achievable. A “last-of-layer” hedge allows entities to hedge an amount of a portfolio that is anticipated to
be outstanding during the term of the hedge. ASU 2022-01 essentially takes the single layer hedge
approach of the “last-of-layer” hedge from ASU 2017-12 and expands it to multiple layers and refers to
this hedge accounting method as the portfolio layer method.
A.1.1 Effective date and transition considerations
For public business entities, ASU 2022-01 is effective for fiscal years beginning after December 15, 2022,
and interim periods within those fiscal years. For all other entities, this ASU is effective for fiscal years
beginning after December 15, 2023, and interim periods within those fiscal years. Early application of this
ASU is permitted. If an entity adopts ASU 2022-01 in an interim period, the effect of adoption related to
basis adjustments should be reflected as of the beginning of the fiscal year of adoption. Upon adoption,
entities may designate multiple hedged layers prospectively. Entities must apply the amendments related
to hedge basis adjustments, except for those related to disclosures, on a modified retrospective basis
using a cumulative-effect adjustment to the opening balance of retained earnings on the date of initial

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application. Entities may either apply the amendments related to disclosures prospectively from the date
of initial application or retrospectively to each prior period presented after the date adopting ASU 2017-
12.
In addition, entities may elect to reclassify debt securities classified in the held-to-maturity category at the
date of adoption to the available-for-sale category only if the entity applies portfolio layer method hedging
to a closed portfolio that includes those debt securities.

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Appendix B: Acronyms, definitions and literature references

Several acronyms are used throughout this guide and references are made to specific topics and
subtopics in the ASC. This appendix includes an acronym legend, which lists the acronyms and their
corresponding definitions, definitions of certain key terms and a literature listing of ASUs and ASC topics
and subtopics referred to throughout this guide with their corresponding titles.
Acronym legend

Acronym Definition

AOCI Accumulated other comprehensive income

ARRC Alternative Reference Rates Committee

ASC FASB’s Accounting Standards Codification

ASU Accounting Standards Update

CDO Collateralized debt obligation

CPI Consumer Price Index

FASB Financial Accounting Standards Board

FVO Fair value option

GAAP Generally accepted accounting principles

IPO Initial public offering

ISO Independent system operator

LIBOR London Interbank Offered Rate

ROAP Removal of accounts provisions

RTO Regional Transmission Organizations

S&P 500 Standard and Poor’s 500 index

SEC Securities and Exchange Commission

SOFR Secured Overnight Financing Rate

Definitions
Several terms with specific meaning are used throughout this guide. Those terms and the corresponding
definition in the Master Glossary of the ASC are provided in the table that follows, except for the definition
of private company, which is not defined in the Master Glossary, but for which we have provided a
definition for purposes of its use in this guide.

Term Definition
Active market A market in which transactions for the asset or liability take place with sufficient
frequency and volume to provide pricing information on an ongoing basis.

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Term Definition
Beneficial interest Beneficial interests are defined in the ASC Master Glossary as rights to receive all
or portions of specified cash inflows received by a trust or other entity, including,
but not limited to the following:
• Senior and subordinated shares of interest, principal, or other cash inflows to
be passed-through or paid-through
• Premiums due to guarantors
• Commercial paper obligations
Residual interests, whether in the form of debt or equity
Capacity contract An agreement by an owner of capacity to sell the right to that capacity to another
party so that it can satisfy its obligations. For example, in the electric industry,
capacity (sometimes referred to as installed capacity) is the capability to deliver
electric power to the electric transmission system of an operating control area.
Carrying amount For a receivable, the face amount increased or decreased by applicable accrued
interest and applicable unamortized premium, discount, finance charges, or issue
costs and also an allowance for uncollectible amounts and other valuation
accounts.
Clearly and closely For purposes of determining whether a contract qualifies for the normal
related (for the purchases and normal sales scope exception, the application of the phrase not
purpose of clearly and closely related to the asset being sold or purchased shall involve an
determining whether analysis of both qualitative and quantitative considerations.
a contract qualifies
for the normal
purchases and
normal sales scope
exception)
Contractual net In this form of net settlement, neither party is required to deliver an asset that is
settlement associated with the underlying and that has a principal amount, stated amount,
face value, number of shares, or other denomination that is equal to the notional
amount (or the notional amount plus a premium or minus a discount). (For
example, most interest rate swaps do not require that either party deliver interest
bearing assets with a principal amount equal to the notional amount of the
contract.) Net settlement may be made in cash or by delivery of any other asset
(such as the right to receive future payments—see the discussion beginning in
paragraph 815-10-15-104) whether or not that asset is readily convertible to cash.
Debt security Any security representing a creditor relationship with an entity. The term debt
security also includes all of the following:
a. Preferred stock that by its terms either must be redeemed by the issuing
entity or is redeemable at the option of the investor
b. A collateralized mortgage obligation (or other instrument) that is issued in
equity form but is required to be accounted for as a nonequity instrument
regardless of how that instrument is classified (that is, whether equity or debt)
in the issuer's statement of financial position
c. U.S. Treasury securities

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Term Definition
d. U.S. government agency securities
e. Municipal securities
f. Corporate bonds
g. Convertible debt
h. Commercial paper
i. All securitized debt instruments, such as collateralized mortgage obligations
and real estate mortgage investment conduits
j. Interest-only and principal-only strips.

The term debt security excludes all of the following:

a. Option contracts
b. Financial futures contracts
c. Forward contracts
d. Lease contracts
e. Receivables that do not meet the definition of security and, so, are not debt
securities, for example:
1. Trade accounts receivable arising from sales on credit by industrial or
commercial entities
2. Loans receivable arising from consumer, commercial, and real estate
lending activities of financial institutions

Derivative A derivative instrument is a financial instrument or other contract with all of the
following characteristics:
a. 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:
1. One or more underlyings
2. One or more notional amounts or payment provisions or both.
b. 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.
c. Net settlement. The contract can be settled net by any of the following means:
1. Its terms implicitly or explicitly require or permit net settlement.
2. It can readily be settled net by a means outside the contract.
3. It provides for delivery of an asset that puts the recipient in a position not
substantially different from net settlement.

Discount The difference between the net proceeds, after expense, received upon issuance
of debt and the amount repayable at its maturity. See premium.

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Term Definition

Embedded Implicit or explicit terms that affect some or all of the cash flows or the value of
derivative other exchanges required by a contract in a manner similar to a derivative
instrument.

Equity security Any security representing an ownership interest in an entity (for example,
common, preferred, or other capital stock) or the right to acquire (for example,
warrants, rights, forward purchase contracts, and call options) or dispose of (for
example, put options and forward sale contracts) an ownership interest in an
entity at fixed or determinable prices. The term equity security does not include
any of the following:
a. Written equity options (because they represent obligations of the writer, not
investments)
b. Cash-settled options on equity securities or options on equity-based indexes
(because those instruments do not represent ownership interests in an entity)
Convertible debt or preferred stock that by its terms either must be redeemed by
the issuing entity or is redeemable at the option of the investor.
Financial asset Cash, evidence of an ownership interest in an entity, or a contract that conveys to
one entity a right to do either of the following:
a. Receive cash or another financial instrument from a second entity
b. Exchange other financial instruments on potentially favorable terms with the
second entity.

Host contract A contract that embodies both an embedded derivative and a host contract.

Lease term The noncancellable period for which a lessee has the right to use an underlying
asset, together with all of the following:
a. Periods covered by an option to extend the lease if the lessee is reasonably
certain to exercise that option
b. Periods covered by an option to terminate the lease if the lessee is
reasonably certain not to exercise that option
c. Periods covered by an option to extend (or not to terminate) the lease in
which exercise of the option is controlled by the lessor.

Loan A contractual right to receive money on demand or on fixed or determinable dates

that is recognized as an asset in the creditor's statement of financial position.
Examples include but are not limited to accounts receivable (with terms
exceeding one year) and notes receivable.
Loan commitment Legally binding commitments to extend credit to a counterparty under certain
prespecified terms and conditions. They have fixed expiration dates and may
either be fixed-rate or variable-rate. Loan commitments can be either of the
following:
a. Revolving (in which the amount of the overall commitment is reestablished
upon repayment of previously drawn amounts)
b. Nonrevolving (in which the amount of the overall commitment is not
reestablished upon repayment of previously drawn amounts).

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Term Definition
Loan commitments can be distributed through syndication arrangements, in which
one entity acts as a lead and an agent on behalf of other entities that will each
extend credit to a single borrower. Loan commitments generally permit the lender
to terminate the arrangement under the terms of covenants negotiated under the
agreement.
Market risk The risk that the fair value or future cash flows of a financial instrument will
fluctuate because of changes in market prices. Market risk comprises the
following:
a. Interest rate risk
b. Currency risk
c. Other price risk.

Mortgage-backed Securities issued by a governmental agency or corporation (for example,

securities Government National Mortgage Association [GNMA] or Federal Home Loan
Mortgage Corporation [FHLMC]) or by private issuers (for example, Federal
National Mortgage Association [FNMA], banks, and mortgage banking entities).
Mortgage-backed securities generally are referred to as mortgage participation
certificates or pass-through certificates. A participation certificate represents an
undivided interest in a pool of specific mortgage loans. Periodic payments on
GNMA participation certificates are backed by the U.S. government. Periodic
payments on FHLMC and FNMA certificates are guaranteed by those
corporations, but are not backed by the U.S. government.
Normal purchases Normal purchases and normal sales are contracts that provide for the purchase or
and normal sales sale of something other than a financial instrument or derivative instrument that
will be delivered in quantities expected to be used or sold by the reporting entity
over a reasonable period in the normal course of business.
Notional amount A notional amount is a number of currency units, shares, bushels, pounds, or
other units specified in the contract. Other names are used, for example, the
notional amount is called a face amount in some contracts. The settlement of a
derivative instrument with a notional amount is determined by interaction of that
notional amount with the underlying. The interaction may be simple multiplication,
or it may involve a formula with leverage factors or other constants. As defined in
the glossary, the effective notional amount is the stated notional amount adjusted
for any leverage factor. If a requirements contract contains explicit provisions that
support the calculation of a determinable amount reflecting the buyer’s needs,
then that contract has a notional amount. See paragraphs 815-10-55-5 through
55-7 for related implementation guidance. For implementation guidance on
identifying a commodity contract’s notional amount, see paragraph 815-10-55-5.
Payment provision As defined in the glossary, a payment provision specifies a fixed or determinable
settlement to be made if the underlying behaves in a specified manner. For
example, a derivative instrument might require a specified payment if a
referenced interest rate increases by 300 basis points.
Premium The excess of the net proceeds, after expense, received upon issuance of debt
over the amount repayable at its maturity. See discount.
Readily convertible Assets that are readily convertible to cash have both of the following:
to cash a. Interchangeable (fungible) units

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Term Definition
b. Quoted prices available in an active market that can rapidly absorb the
quantity held by the entity without significantly affecting the price

Regular-way Regular-way security trades are defined as contracts that provide for delivery of a
security trades security within the period of time (after the trade date) generally established by
regulations or conventions in the marketplace or exchange in which the
transaction is being executed. For example, a contract to purchase or sell a
publicly traded equity security in the United States customarily requires settlement
within three business days. If a contract for purchase of that type of security
requires settlement in three business days, the regular-way security trades scope
exception applies, but if the contract requires settlement in five days, the regular-
way security trades scope exception does not apply unless the reporting entity is
required to account for the contract on a trade-date basis.
Underlying An underlying is a variable that, along with either a notional amount or a payment
provision, determines the settlement of a derivative instrument. An underlying
usually is one or a combination of the following:
c. A security price or security price index
d. A commodity price or commodity price index
e. An interest rate or interest rate index
f. A credit rating or credit index
g. An exchange rate or exchange rate index
h. An insurance index or catastrophe loss index
i. A climatic or geological condition (such as temperature, earthquake severity,
or rainfall), another physical variable, or a related index
j. The occurrence or nonoccurrence of a specified event (such as a scheduled
payment under a contract)

Literature listing

ASC topic or
subtopic Title
210-20 Balance Sheet – Offsetting
230 Statement of Cash Flows
235 Notes to Financial Statements
310 Receivables
310-10 Receivables—Overall
320 Investments—Debt Securities
325-30 Investments—Other—Investments in Insurance Contracts
326 Financial Instruments—Credit Losses
450 Contingencies
460 Guarantees
480 Distinguishing Liabilities from Equity
606 Revenue from Contracts with Customers
718 Compensation—Stock Compensation

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ASC topic or
subtopic Title
815 Derivatives and Hedging
815-10 Derivatives and Hedging—Overall
815-15 Derivatives and Hedging—Embedded Derivatives
815-40 Derivatives and Hedging—Contracts in Entity’s Own Equity
815-45 Derivatives and Hedging—Weather Derivatives
820 Fair Value Measurement
825-10 Financial Instruments—Overall
825-20 Financial Instruments—Registration Payment Arrangements
840 Leases
842 Leases
860 Transfers and Servicing
845 Nonmonetary Transactions
944 Financial Services—Insurance
944-20 Financial Services—Insurance—Insurance Activities
954 Health Care Entities
960 Defined Benefit Pension Plans

Other
literature Title
ASU 2018-12 Financial Services—Insurance (Topic 944): Targeted Improvements to the Accounting for
Long-Duration Contracts
ASU 2020-01 Investments—Equity Securities (Topic 321), Investments—Equity method and Joint
Ventures (Topic 323), and Derivatives and Hedging (Topic 815) —Clarifying the
Interactions Between Topic 321, Topic 323, and Topic 815 (a Consensus of the
Emerging Issues Task Force)

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