ASU 2025-07: FASB Simplifies Derivative Accounting and Clarifies Revenue Recognition for Share-Based Payments from Customers
A practical guide to ASU 2025-07’s two major accounting changes
Executive Summary
On September 29, 2025, the FASB issued Accounting Standards Update No. 2025-07, addressing two distinct but important accounting challenges that have plagued practitioners for years.
Key Changes:
New derivatives scope exception: Contracts with underlyings based on operations or activities specific to one of the parties (such as EBITDA targets, regulatory approval, litigation outcomes, or greenhouse gas emissions reduction goals) are excluded from derivative accounting if not exchange-traded
Four exclusions to the scope exception: The exception does not apply to underlyings based on (1) market rates, prices, or indices, (2) price or performance of financial assets/liabilities, (3) contracts on entity’s own equity under Subtopic 815-40, or (4) call/put options on debt instruments
Revenue recognition clarification: Share-based noncash consideration (warrants, shares, stock options) received from customers must be accounted for under Topic 606 until the entity’s right to receive or retain the consideration is unconditional—only then does Topic 815 or 321 apply
Performance-based focus: The right to share-based consideration becomes “unconditional” once all performance-related contingencies are resolved, even if market conditions or other non-performance contingencies remain
Effective date: Annual periods beginning after December 15, 2026, and interim periods within those years; early adoption permitted for both issues simultaneously
Practical impact: Expected to reduce costs and complexity for ESG-linked instruments, R&D funding arrangements, litigation funding, and earnout provisions while improving consistency in revenue recognition across different forms of consideration
To a Derivative Specialist, Everything Looks Like a Derivative
You know the old saying: to a hammer, everything looks like a nail. Well, to a derivative specialist , everything looks like a derivative. And that’s become a problem.
When Statement 133 was issued back in 1998, the FASB deliberately created a characteristics-based definition of a derivative rather than a list of specific instruments. This was nice in theory but created problems in practice, particularly as the business world evolved in ways the Board couldn’t have anticipated.
The definition worked well enough for traditional derivatives: interest rate swaps, currency forwards, commodity futures. But then the business environment changed. Companies began issuing sustainability-linked bonds where interest rates adjust based on achieving greenhouse gas emission targets. Biotech companies entered into complex R&D funding arrangements where payments depend on regulatory approvals and development milestones. Litigation funders agreed to finance lawsuits in exchange for a percentage of successful outcomes.
All of these arrangements technically met the definition of a derivative under Topic 815. Suddenly, derivative specialists found themselves analyzing earnout provisions, ESG metrics, and litigation contingencies as if they were interest rate swaps. And that created real problems.
Why This Mattered (And Why It Was Getting Worse)
The summary to the ASU captures the challenge: stakeholders cited “the changing business environment and the broad application of the derivative definition and the complexity of applying scope exceptions to certain contracts.”
The key issue? These contracts relate to the performance of a party to the contract, and accounting for them as derivatives measured at fair value “does not provide decision-useful information.”
Consider a research funding arrangement where a pharmaceutical company receives $50 million to develop a drug, with contingent payments tied to regulatory approval and future sales milestones. Under the old rules, the company might need to recognize a derivative liability for those contingent payments while the related drug candidate doesn’t meet recognition criteria. You end up booking a liability with no offsetting asset, even though economically you’ve received funding for development work.
The Board was blunt in its assessment: derivative accounting for these arrangements “often results in assets and liabilities being recorded at amounts that would be unlikely to be realized or settled at, further reducing their predictive value for investors.” Additionally, it “may effectively override the accounting guidance that was specifically created for certain types of transactions, such as those evaluated under Subtopic 730-20, Research and Development—Research and Development Arrangements.”
The costs were significant too. Companies spent substantial time and resources evaluating whether contracts contained derivatives, applying complex scope exceptions, and building valuation models for features that often bore little resemblance to traditional derivatives. Some companies simply avoided these types of arrangements altogether.
The Solution: A New Scope Exception Based on Your Own Performance
The Board’s solution is simple: if a contract’s settlement is based on operations or activities specific to one of the parties to the contract, it’s excluded from derivative accounting (assuming it’s not exchange-traded).
Here’s the actual language from the new paragraph 815-10-15-59(e):
“An underlying that is based on operations or activities specific to one of the parties to the contract. This scope exception applies to underlyings based on the financial operating results (or components of those results) of one of the parties to the contract. This scope exception also applies to underlyings based on the occurrence or nonoccurrence of an event specific to the operations or activities of one of the parties to the contract (such as obtaining regulatory approval, achieving a product development milestone, or achieving a greenhouse gas emissions reduction target). When evaluating whether operations or activities are specific to one of the parties to the contract, an entity does not need to consider whether the outcome is within its control.”
This captures underlyings like:
Financial metrics: EBITDA, net income, gross profit, expenses
Operational events: Obtaining regulatory approval, achieving product development milestones, successful litigation outcomes
Sustainability metrics: Achieving greenhouse gas emissions reduction targets, meeting diversity goals, hitting renewable energy usage targets
The key insight: these underlyings relate to a party’s own performance, not market-based variables that create the asymmetric risk/reward profile we associate with traditional derivatives.
What Doesn’t Qualify: Four Important Carve-Outs
The Board recognized that a principles-based scope exception could be too broad, so they built in four exclusions:
1. Market rates, prices, and indices - Underlyings based on a market rate, market price, or market index don’t qualify. This preserves derivative accounting for traditional derivatives. If Entity A operates in the gold market but enters into a contract tied to the market price of gold, that’s still a derivative.
2. Price or performance of financial assets/liabilities - Underlyings based on the price or performance (including default) of a financial asset or financial liability don’t qualify. This keeps credit default swaps and guarantee contracts in derivative accounting where they belong.
3. Contracts on entity’s own equity - Contracts subject to Subtopic 815-40 (like conversion features on convertible debt) don’t qualify. The Board excluded these after comment letter feedback about increased complexity and potential asymmetric accounting between freestanding instruments and embedded features.
4. Call and put options on debt instruments - Options evaluated under paragraphs 815-15-25-41 through 25-43 don’t qualify. This preserves existing, well-understood accounting.
Key Clarifications
Control doesn’t matter: The paragraph explicitly states “an entity does not need to consider whether the outcome is within its control.” The Board explained that requiring a control assessment would be “subjective, be challenging to apply, and potentially create diversity in practice.” Regulatory approval isn’t fully controlled by the applicant, but it still relates to their operations.
Consolidated group perspective: For this scope exception only, “party to the contract includes the parent, subsidiaries, or other entities consolidated by the parent for both consolidated financial statements and the standalone financial statements of individual entities within the consolidated group.” An ESG-linked bond issued by a subsidiary that references parent-level emissions targets can still qualify.
Judgment for financial metrics: The Board acknowledged that “the determination of whether a financial statement metric will qualify for the scope exception… would be a matter of judgment” but noted that “many financial statement metrics will qualify for the scope exception.” Interest income or credit losses at a financial institution will often qualify, even though they relate to financial assets.
Examples That Bring This To Life
The standard includes detailed examples illustrating when the scope exception does and doesn’t apply:
Research funding (Case A): Contingent payments tied to regulatory approval and gross profit milestones qualify
Monetization transactions (Case B): Licensing royalties based on regulatory approval and sales qualify
Sustainability-linked bonds (Case C): Interest rate adjustments for failing GHG targets qualify
Litigation funding (Cases D & E): Payments contingent on successful litigation outcomes qualify
Commodities contracts (Case F): Payments based on market price of gold don’t qualify (market-based exclusion)
Earnout arrangements (Case H): Payments based on EBITDA targets qualify
Stock price differentials (Case I): Protection payments based on stock price don’t qualify (market-based exclusion)
Credit default swaps (Case J): Protection based on borrower default doesn’t qualify (financial asset performance exclusion)
Battle of the Topics: When Financial Instruments Meet Revenue Recognition
Now let’s turn to the second issue, which became something of a turf war between different camps of accounting specialists.
Picture the scene: Your company enters into a contract to deliver 5,000 units to a customer. The customer will pay $100 per unit upon delivery, plus grant you 100 warrants if you deliver everything within two years.
The financial instruments folks said: “Those warrants are clearly a financial instrument! Recognize a derivative asset at contract inception under Topic 815. Or at least an equity security under Topic 321.”
The revenue recognition gurus countered: “Wait a minute—those warrants are consideration in a revenue contract! They should follow Topic 606 guidance. You haven’t earned them yet!”
The confused controller asked: “Can someone just tell me what to do?”
This wasn’t a theoretical debate—real diversity existed in practice, and the FASB received feedback that “there is a lack of clarity about which guidance an entity should apply to recognize share-based noncash consideration.”
The Board’s Intent (That Got Lost in Translation)
Here’s the thing: the FASB always intended for Topic 606 to apply. When they originally issued ASU 2014-09, they included explicit guidance saying so. But that guidance got superseded in a subsequent update (ASU 2018-07), and the clarification disappeared even though “the Board’s intent for an entity to apply Topic 606 to account for share-based noncash consideration from a customer in a revenue contract did not change.”
Without explicit guidance, the financial instruments camp and the revenue recognition camp each interpreted the silence in their favor.
The Clarification: Revenue Recognition Wins (But Only Until You’ve Earned It)
The standard now clearly states in new paragraph 606-10-15-3A:
“An entity shall apply the guidance in this Topic, including the guidance on noncash consideration in paragraphs 606-10-32-21 through 32-24, to a contract with share-based noncash consideration (for example, shares, share options, or other equity instruments) from a customer for the transfer of goods or services. The guidance in other Topics (including Topic 815 on derivatives and hedging and Topic 321 on equity securities) does not apply to share-based noncash consideration from a customer for the transfer of goods or services unless and until the entity’s right to receive or retain the share-based noncash consideration is unconditional under this Topic.”
The key phrase: “unless and until the entity’s right to receive or retain the share-based noncash consideration is unconditional.”
Your right is unconditional when only the passage of time is required before payment is due—consistent with how Topic 606 defines a receivable. But here’s the critical nuance: evaluate only contract terms that relate to your performance obligations (or specific outcomes of your performance).
So if the warrants vest when you:
Complete delivery of goods → That’s performance-related, so apply Topic 606
Meet quality specifications in the contract → That’s performance-related, so apply Topic 606
Achieve regulatory approval required for the contract → That’s performance-related, so apply Topic 606
But if the warrants vest when:
The customer’s stock price reaches $100 → That’s not performance-related, so if you’ve completed performance, apply Topic 815/321
Three years pass after delivery is complete → That’s just passage of time, so apply Topic 815/321
Once performance-related contingencies are resolved, your right becomes unconditional under Topic 606, and you hand off to the financial instruments camp.
A Worked Example
The new Example 31A illustrates the accounting:
Setup: Deliver 5,000 units at $100 each. Receive 100 warrants (fair value $100,000 at inception) if all units delivered within 2 years.
Year 1: Deliver 3,000 units. Transaction price is $600,000 (5,000 × $100 + $100,000), allocated at $120 per unit. Recognize revenue of $360,000, cash of $300,000, and a contract asset of $60,000 for the earned portion of the warrants. Don’t mark the warrants to market. Do assess the contract asset for impairment.
Year 2: Deliver remaining 2,000 units. Recognize revenue of $240,000 and contract asset of $40,000. Now all units are delivered—your right to the warrants is unconditional. Derecognize the $100,000 contract asset and start applying Topic 815 or 321 to the warrants.
The revenue camp was right about: When to recognize the consideration (progressively as performance obligations are satisfied)
The financial instruments camp was right about: How to account for the warrants once earned (apply Topic 815 or 321 for subsequent measurement)
Everyone wins—or at least everyone gets a piece of the action.
Why This Asset-Focused Approach Makes Sense
The Board chose this approach because it treats share-based consideration consistently with other assets arising from revenue contracts. The Board rejected the alternative of recognizing a financial instrument at contract inception, noting it “could result in consideration and revenue in a revenue contract with share-based noncash consideration from a customer being recognized in different periods and in a different manner than a revenue contract with cash consideration.”
Why would you recognize warrants at inception but not a cash receivable? Both are consideration in the same revenue contract. The asset-focused approach maintains consistency.
A nice bonus: this approach “is expected to improve the symmetry with the grantor’s accounting under Topic 718” because both parties focus on performance-related contingencies (excluding market conditions), making it more likely both recognize the transaction in the same period.
What the Board Didn’t Address
Comment letters asked for guidance on:
Measuring fair value of share-based consideration at inception
Subsequent measurement and impairment of related contract assets
Initial measurement when moving from Topic 606 to Topic 815/321
The Board declined, observing these “measurement issues are not unique to revenue contracts with share-based noncash consideration from a customer” and “are not a result of the amendments in this Update.” The existing guidance in Topic 606 and the basis for conclusions in ASU 2016-12 provides sufficient direction.
Implementation: What You Need to Do
Effective date: Annual periods beginning after December 15, 2026, with interim periods within those years. Early adoption is permitted for both issues simultaneously.
For the Derivatives Scope Exception
1. Inventory your contracts: Start by identifying arrangements that might qualify—ESG-linked debt, R&D funding, litigation funding, earnout arrangements, monetization transactions tied to operational milestones.
2. Apply the test systematically: For each contract, determine if the underlying is based on operations or activities specific to a party, then check the four exclusions (market-based, financial asset/liability performance, own equity under 815-40, and call/put options on debt).
3. Consider financial statement implications:
ESG-linked debt: Variable interest expense rather than fair value changes
R&D funding: Apply Subtopic 730-20 guidance
Litigation funding: Liability with imputed interest
Earnout arrangements: Adjust asset cost when resolved
4. Choose your transition method:
Prospective (new contracts only): Minimizes implementation costs but creates mixed accounting in the transition period.
Modified retrospective (adjust opening retained earnings): Provides clean break and consistent accounting. Includes two optional fair value elections: (a) continue fair value accounting for former derivatives if desired; and (b) revoke fair value option if elected solely to avoid bifurcation.
For Share-Based Noncash Consideration
1. Identify revenue contracts with equity consideration: Look for warrants, shares, or stock options received from customers as performance bonuses or consideration.
2. Analyze contingencies: Separate performance-related contingencies (completing delivery, meeting quality standards, achieving contract milestones) from non-performance-related ones (customer stock price, market conditions, post-performance passage of time).
3. Understand measurement:
Estimate fair value at contract inception
Include this in transaction price
Recognize contract assets as you perform
Don’t mark to market during performance period
Do assess contract assets for impairment
Handle probability of vesting through variable consideration assessment (not in initial fair value)
4. Choose transition method: Prospective (new contracts only) or modified retrospective (adjust opening retained earnings for existing contracts).
Timeline for Implementation
Assuming calendar year-end, no early adoption:
2025-Q4 through 2026-Q2: Complete contract inventory, choose transition approach, draft policy updates
2026-Q3: Finalize implementation, train staff, engage auditors
2026-Q4: Complete documentation, prepare disclosures
January 1, 2027: Effective date
Consider early adoption if you have material contracts that would benefit from the changes and can complete implementation work in 2025.
Documentation and Controls
Update your accounting policies to address:
How you identify contracts potentially affected
Your process for evaluating the “operations or activities” criterion
How you assess the four exclusions for derivatives
How you determine when share-based consideration rights become unconditional
Documentation requirements for scope exception determinations
The 57 paragraphs of basis for conclusions provide valuable insights into the Board’s reasoning—use them when exercising judgment.
Why These Changes Matter
Both amendments reflect the FASB’s pragmatic response to implementation challenges. The derivatives scope refinement acknowledges that the 1998 definition, while conceptually sound, captured arrangements that don’t exhibit the economic characteristics we associate with derivatives. The revenue clarification restores explicit guidance that inadvertently disappeared.
For practitioners, these changes mean:
Less time spent evaluating derivative scope exceptions for operations-based arrangements
More consistent accounting for revenue contracts regardless of consideration form
Better alignment between accounting outcomes and economic substance
Reduced costs for complex valuations that don’t reflect how these instruments actually behave
The standard becomes effective for annual periods beginning after December 15, 2026. With clear examples, flexible transition options, and thoughtful carve-outs, the FASB has provided tools to implement these changes in a way that improves financial reporting without unnecessary disruption.
To the derivative specialists: not everything is a derivative after all.
To the revenue recognition gurus: you were right about share-based consideration.
And to the rest of us: we finally have clarity on two issues that have caused way too much confusion.