In the simplest terms, a derivative is an instrument whose value depends on (or is derived from) the value of an underlying variable or variables, such as the prices of traded assets. Most derivatives are net-settled contracts that allow the holder to benefit from changes in the value of a referenced asset or other market variable while making a smaller initial investment than would be required to own that asset and experience similar gains and losses.

There are different types of derivative contracts, but the most common ones are forwards, futures, options, and swaps. When an entity enters into these types of contracts, it may be fairly obvious that such a contract meets the definition of a derivative. However, the accounting definition of a derivative sometimes encompasses other types of contracts that are not commonly thought of as derivatives, such as financial guarantees and contracts to purchase materials or power, or commodity contracts that require the physical delivery of assets that are readily convertible to cash.

In accordance with ASC 815-10-15-83, all three of the following criteria must be satisfied for a contract to meet the definition of a derivative:

An instrument that does not meet the definition of a derivative in its entirety may contain contractual terms or features that affect the cash flows, values, or other exchanges required by the terms of the instrument in a manner similar to a derivative. Such terms or features are “embedded” in the overall arrangement or contract and are referred to as “embedded derivatives.”

Under ASC 815-15-25-1, an entity is required to bifurcate and separately account for a feature embedded within another contract (the host contract) if all three of the following conditions are met:

A key underlying principle of ASC 815 is that derivatives represent either assets or liabilities in the statement of financial position, and those assets or liabilities should be measured initially and subsequently at fair value by applying the concepts of ASC 820. See Deloitte’s Roadmap Fair Value Measurements and Disclosures (Including the Fair Value Option) for more guidance. The accounting for changes in the fair value of a derivative instrument depends on whether it has been designated as a hedging instrument in a qualified hedging relationship. Derivatives that are designated as a hedging instrument in a qualified hedging relationship are eligible for specialized hedge accounting. See Deloitte’s Roadmap Hedge Accounting for more information. Other than in limited scenarios, the gain or loss on a derivative instrument that has not been designated as a hedging instrument should be recognized in current-period earnings.

In addition, if any feature of an instrument has been identified and bifurcated as an embedded derivative, the entity should apply the accounting in ASC 815 related to measurement and recognition as if that embedded derivative were a free-standing derivative. Therefore, such an embedded derivative should be initially recorded at fair value and remeasured to its fair value in each reporting period. Unless the bifurcated embedded derivative is designated in a qualified hedging relationship, changes in the derivative’s fair value are recognized through earnings in each reporting period.

Derivatives scope refinements (ASC 815) — FASB recognition and measurement project

On July 23, 2024, the FASB issued a proposed ASU that would (1) refine the scope of the guidance on derivatives in ASC 815 and (2) clarify the scope of the guidance on share-based payments from a customer in ASC 606. The proposed ASU is intended to address concerns about the application of derivative accounting to contracts that have features based on the operations or activities of one of the parties to the contract and to reduce diversity in the accounting for share-based payments in revenue contracts. Comments on the proposal are due by October 21, 2024.

The proposed ASU would refine the scope of ASC 815 to exclude certain “contracts with underlyings based on operations or activities specific to one of the parties to the contract.” Contracts that may qualify for this exception would include those in which the underlying is a business operation or an event such as obtaining regulatory approval or achieving specific business milestones. The proposal would also change how the “predominant characteristics” of a contract are assessed when a contract has multiple underlyings, some of which qualify for scope exceptions and some of which do not.

The proposed ASU would also clarify that when an entity has a right to receive a share-based payment from its customer in connection with a contract with that customer, the share-based payment would be accounted for as a noncash consideration in the scope of ASC 606. That is, the proposed ASU provides that “unless and until the share-based payment is recognized as an asset” in accordance with ASC 606, the right to receive the share-based payment would not be in the scope of ASC 815 or ASC 321. Reporting entities would look to ASC 321 or ASC 815, as applicable, for subsequent measurement, which might result in the recognition of an immediate gain or loss once that share-based payment is received.

The Board will discuss feedback on the proposed ASU at future meetings. Entities should monitor this project on derivatives scope refinements with their accounting advisers for any new developments. For more information about the proposed ASU, see Deloitte’s August 2, 2024, Heads Up.

Definition of a derivative — FASB research project

As of the date of this Roadmap, the FASB’s research agenda still includes a project on the definition of a derivative. The objective of the research project is to consider possible refinements to the scope of ASC 815, including potential application guidance specific to certain arrangements such as research and development funding arrangements and sustainability-linked financial instruments (see below). Although this remains a separate research agenda project, some of these objectives may be addressed by the derivatives scope refinements project discussed above.

Entities should monitor this research project with their accounting advisers for any new developments.