ASC 815 Derivative Scope and Embedded Derivatives: Is It a Derivative, and Does It Split Out?

Most small-company clients never sign an ISDA agreement, yet many hold derivatives without knowing it. A supply contract priced in a foreign currency, a note with an index-linked return and a forward purchase agreement can each fall inside ASC 815. The accounting consequence is large: fair value on the balance sheet and changes through earnings.

This guide gives the scoping questions in the order the file should answer them, the scope exceptions that matter most, the embedded derivative test and a worked entry. For hedge accounting once a contract is determined to be a derivative, see /us/blog/asc-815-interest-rate-swap-cash-flow-hedge-entries.

When is a contract a derivative?

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

• An underlying, and a notional amount or payment provision. The underlying is a variable such as a security price, commodity price, interest rate or exchange rate that determines settlement. It is not the asset itself. A notional amount is the quantity in the contract, such as currency units, shares or bushels. A payment provision sets a fixed or determinable settlement when the underlying behaves in a specified way, for example a payment of $5 million if interest rates rise by 200 basis points.
• No initial net investment, or a smaller one than similar contracts need. An option premium can count as an investment. Exchanging currencies of equal fair value, as in a currency swap, is not an initial net investment. The test is whether the investment is zero or smaller than other contracts with a similar response to market changes would need, so the conclusion is judged case by case.
• Net settlement. The contract requires or permits net settlement in its terms, can readily be settled net by a means outside the contract, or delivers an asset that is readily convertible to cash, such as an exchange-traded security.

ASC 815 applies to all contracts that meet the definition unless a scope exception applies.

Which contracts are excluded?

Some contracts that meet the definition are excluded so that ASC 815 does not burden industries and markets where such contracts were traditionally not accounted for as derivatives. The exceptions include regular-way security trades, normal purchases and normal sales, certain insurance contracts, certain financial guarantee contracts, certain loan commitments, certain contracts involving the entity's own equity, leases, residual value guarantees and registration payment arrangements. Own-equity contracts connect to /us/standards/asc-480-distinguishing-liabilities-from-equity.

The normal purchases and normal sales exception is the one clients use most often, and it has conditions. KPMG's handbook lists the requirements, and all of them must be met:

• The contract is for something other than a financial instrument or derivative, delivered in quantities the entity expects to use or sell over a reasonable period in the normal course of business.
• The price is not based on an underlying that is not clearly and closely related to the asset bought or sold, and any foreign currency pricing meets the currency tests in the standard.
• Physical delivery is probable, and the contract will not settle net. The entity keeps assessing this over the term.
• The entity documents the designation as normal purchases or normal sales at inception. The election is not permitted to change afterward, and the eligibility assessment is made only at inception.
• Net settlement of contracts in a group of similarly designated contracts calls into question the classification of all of them.
• Contracts that require periodic cash settlement of gains and losses, such as exchange-traded futures, do not qualify.

A derivative outside every exception is recognized at fair value under ASC 820. The treatment of a designated hedge depends on the type of hedging relationship.

What is an embedded derivative?

A hybrid instrument is a contract that holds both an embedded derivative and a host contract. The host is the instrument that would have been issued if the hybrid had no embedded derivative. A structured note that pays interest tied to the S&P 500 Index is the standard case: the index-linked adjustment is the embedded derivative, and the debt paying fixed interest and principal is the host.

An embedded derivative is separated from its host and accounted for as a derivative if and only if all three criteria are met:

1. Its economic characteristics and risks are not clearly and closely related to those of the host.
2. The hybrid instrument is not remeasured at fair value, with changes in earnings, under otherwise applicable GAAP.
3. A separate instrument with the same terms would be a derivative under ASC 815.

Two consequences follow. A contract already carried at fair value through earnings needs no embedded derivative assessment. An entity cannot separate an embedded derivative that fails the criteria, even by choice.

When separation is required, the entity can bifurcate, measuring the embedded derivative at fair value with changes in earnings and accounting for the host under the GAAP that applies to similar instruments. Alternatively, it can irrevocably elect the fair value option for the entire hybrid, available only at acquisition or issuance or at a remeasurement event. For convertible instruments, see /us/standards/asc-470-20-convertible-debt-asu-2020-06.

Currency features show up in ordinary contracts. KPMG's handbook lists the currencies for which an embedded foreign currency feature is not separated: the functional currency of any substantial party to the contract, the currency in which the price of the related good or service is routinely denominated in international commerce, the local currency of any substantial party, and a currency used as if it were functional in a highly inflationary economy. A payment adjustment tied to a currency outside that list, for example a US dollar contract between two US dollar parties whose payments adjust with the USD/JPY rate, needs a bifurcation analysis.

Worked journal entries

An illustration with round numbers. A client issues a $1,000,000 note whose return is tied to an equity index. The terms meet all three criteria, so the index-linked feature is bifurcated. At issuance the embedded derivative has a fair value of $60,000. The illustration assumes the host takes the proceeds left after the derivative.

At year end the fair value of the embedded derivative has risen to $75,000. The $15,000 change goes to earnings:

Without bifurcation the client would show a $1,000,000 note and no derivative, and the earnings effect would never appear.

What changes under ASU 2025-07?

ASU 2025-07 adds a scope exception from derivative accounting for nonexchange-traded contracts whose underlying is based on operations or activities specific to one of the parties to the contract. Some underlyings and features do not qualify. KPMG expects more contracts and embedded features to fall outside ASC 815 as a result. The ASU is effective for annual and interim periods in fiscal years beginning after December 15, 2026, for all entities, and early adoption is permitted. Revenue-based or earnings-based payments in a client's contracts are the first place to look.

Audit angle

1. Read the contracts for features. Scan debt agreements, supply contracts, leases, preferred stock terms and customer contracts for index-linked payments, currency terms, puts, calls and conversion options. This is a completeness test, and it starts with the contract inventory and the legal confirmation process.
2. Test the definition. For each candidate, document the underlying, the notional or payment provision, the initial investment and the net settlement analysis.
3. Test exceptions. For normal purchases and normal sales, agree the designation documentation, check delivery history and look for net settlement that would taint the classification.
4. Test the bifurcation analysis. All three criteria, with the clearly and closely related conclusion supported.
5. Test the fair value. Recompute the embedded derivative from a model or counterparty quote. See /us/blog/asc-820-fair-value-measurement for the hierarchy and disclosures.
6. Check the host. Agree the host carrying amount and recompute the effective interest accretion.
7. Check startup instruments. For convertible notes and SAFEs, see /us/blog/convertible-notes-and-safes-audit-for-startups.

Common misstatements: no derivative recorded for an index-linked or currency-linked feature, the whole hybrid at fair value without an election, a normal purchases designation that was lost through net settlement, and a bifurcated derivative never remeasured after issuance.

CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.

Sources

• KPMG, Handbook: Derivatives and hedging (definition, normal purchases and normal sales, embedded foreign currency features): https://kpmg.com/us/en/frv/reference-library/2026/handbook-derivatives-hedging.html
• KPMG, FASB issues ASU on derivative scope refinements (ASU 2025-07): https://kpmg.com/us/en/frv/reference-library/2025/fasb-issues-asu-derivative-scope-refinements.html
• PwC Viewpoint, Derivatives and hedging guide, 2.3 Definition of a derivative: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/derivatives_and_hedg/derivatives_and_hedg_US/chapter_2_definition_US/23_definition_US.html
• PwC Viewpoint, Derivatives and hedging guide, 2.2 Scope of derivatives guidance: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/derivatives_and_hedg/derivatives_and_hedg_US/chapter_2_definition_US/22_scope_US.html
• PwC Viewpoint, Derivatives and hedging guide, 3.2 Contracts excluded from ASC 815's scope: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/derivatives_and_hedg/derivatives_and_hedg_US/chapter_3_scope_exce_US/32_contracts_exclude_US.html
• PwC Viewpoint, Derivatives and hedging guide, 4.3 Determining if an embedded component should be separated: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/derivatives_and_hedg/derivatives_and_hedg_US/chapter_4_embedded_d_US/43_determining_if_US.html

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error