Post on 07-Apr-2018
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Accounting for Embedded Derivatives
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Outline
Introduction
Definition of a Derivative
Key Terms
Identifying Embedded Derivatives
Accounting for Embedded Derivatives
Example - Debt Host
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Introduction
Embedded derivatives must be bifurcated from the host contract and accounted for
separately if certain requirements are met. For debt and equity instruments,
identifying and determining which features should be accounted for separately can be
extremely difficult and time consuming. The assessment of bifurcation of embeddedderivatives depends on the characteristics of the host contract, which for some
financial instruments with both debt and equity characteristics may be unclear. As a
result of this complexity, many companies have inappropriately accounted for
embedded derivatives. This outline serves as a general introduction to some of the
relevant guidance on this topic.
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Definition of a Derivative
ASC 815-10-15-83 defines a derivative instrument as 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
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Key Terms
Underlying
An underlying is a variable within a derivative instrument that, along with either a notional
amount or a payment provision, determines the settlement amount of a derivative. An
underlying may be the price or rate of an asset or liability but is not the asset or liability itself.
Accordingly, the underlying will generally be the referenced rate or index that determines
whether or not the derivative instrument has a positive or negative value.
Notional amount
A number of currency units, shares, bushels, pounds, or other units specified in a derivative
contract. The notional amount generally represents the second half of the equation that goes
into determining the settlement amount under a derivative instrument. Accordingly, the
settlement of a derivative instrument is often determined by the interaction of the notional
amount and the underlying. The interaction between the notional amount and the underlying
may consist of simple multiplication, or it may involve a formula that has leverage factors or other
constants.
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Key Terms
Payment Provision
Instead of a notional amount, some derivatives contain a payment provision for a fixed or
determinable settlement amount if the underlying behaves in a certain manner. In such cases, the
requirements of ASC 815-10-15-93 are met, even though the settlement of the contract is driven
by the behavior of the underlying alone.
Initial Net Investment
ASC 815 defines a derivative as either a contract that does not require an initial net investment or
a contract that requires an initial net investment that when adjusted for the time value of money,
is less by more than a nominal amount than the initial net investment that would be required
to acquire the asset (or incur an obligation) related to the underlying. A derivative does not
require an initial net investment in a 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 thenotional amount to the underlying. Some derivative instruments might require a mutual
exchange of assets at a contracts inception, in which case the initial net investment would be the
difference between the fair values of the assets exchanged.
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Key Terms
Net Settlement
Whether a contract can be settled net, generally means that a contract can be settled at its
maturity through an exchange of cash instead of through the physical delivery of an asset. A
contract may be considered net settled when its settlement meets one of the following criteria in
ASC 815-10-15-99:
a. Net settlement under contract terms
b. Net settlement through a market mechanism
c. Net settlement by delivery of derivative instrument or asset readily convertible to cash.
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Identification
Host Contract
If derivatives are embedded in a financial instrument or other contract, the base contract is
referred to as the host contract. Examples of host contracts include:
Debt Instruments
Equity Instruments
Leases
Insurance Contracts
Executory Contracts
Hybrid Instrument
The combination of the host contract and the embedded derivative is referred to as the hybrid
instrument.
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Identification
Contracts should be evaluated carefully to determine whether they contain any embedded
derivative features. The following terms may indicate the presence of an embedded derivative:
Right to put, call, repurchase, redeem, return
Right to prepay, repay early, accelerate repayment, early exercise
Right to terminate, cancel or extend
Right to convert
Indexed to, adjusted by
Pricing based on a formula
Conditional, contingent, optional
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Accounting
An embedded derivative would require bifurcation and separate accounting from the host
contract if, and only if, all of the following criteria of ASC 815-15-25-1 are met:
1(a) The economic characteristics and risks of the embedded derivative instrument are not
clearly and closely related to the economic characteristics and risks of the host contract.
1(b) The hybrid instrument is not remeasured at fair value under otherwise applicable
generally accepted accounting principles (GAAP) with changes in fair value reported in
earnings as they occur.
1(c) A separate instrument with the same terms as the embedded derivative instrument
would, pursuant to Section 815-10-15, be a derivative instrument subject to therequirements of this Subtopic. (The initial net investment for the hybrid instrument shall not
be considered to be the initial net investment for the embedded derivative.)
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Accounting
1(a) The economic characteristics and risks of the embedded derivative instrument are not
clearly and closely related to the economic characteristics and risks of the host contract.
This criteria addresses whether the underlying economic characteristics and risks of an
embedded derivative are clearly and closely relatedto the economic characteristics and risks ofthe host contract (ie: do the attributes of a derivative behave in a manner similar to the attributes
of its host contract). For example, if a feature embedded in a debt instrument embodies the
economic characteristics of an equity instrument (e.g., the embedded derivative has a rate of
return that is tied to the S&P 500 Index), it must be separated from the debt host if the
conditions of paragraphs ASC 815-15-25-1(b) and 25-1(c) are met. This is because the economic
characteristics of the embedded derivative (e.g., equity-price risk) and the economic
characteristics of the host contract (e.g., interest rate risk) are dissimilar.
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Accounting
1(b) The hybrid instrument is not remeasured at fair value under otherwise applicable
generally accepted accounting principles (GAAP) with changes in fair value reported in
earnings as they occur.
ASC 815 specifies that hybrid instruments that are remeasured at fair value throughearnings should not be bifurcated into individual components that are separately accounted
for. Bifurcation in these situations is unnecessary, because both instruments are
remeasured at fair value with changes in fair value reported in earnings.
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Accounting
1(c) A separate instrument with the same terms as the embedded derivative instrument would,
pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of this
Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the
initial net investment for the embedded derivative.)
Under the criterion in ASC 815-15-25-1(c), an embedded derivative would cause bifurcation
of the hybrid instrument and require separate accounting only if it meets the definition of a
derivative, if it were a freestanding instrument under ASC 815-10-15-83. However, if the
embedded derivative meets any of the scope exceptions in ASC 815-10-15-13 or ASC 815-
15-15-3 (Refer to DH 2.2, DH 3.2.3 and DH 3.2.4), it would not meet the criterion in ASC
815-15-25-1(c).
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Example - Debt Host
Debt hosts are the most common contracts to include embedded derivatives. Common
provisions in debt hosts that may require bifurcation include the following:
Conversion Features
Puts and Calls Term Extending options
Equity Indexed Interest Payments
Interest rate floors, caps, collars
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Example - Debt Host
Example
Company ABC is a private company. ABC issued a $10,000,000 Debt Instrument with a five year
term. The Debt pays interest at a fixed rate of 4% per annum. The market interest rate is 10% and
the debt was issued at a substantial discount. The debt is convertible at the lenders option into
ABCs shares of common stock upon an IPO. The lender can also put the debt back at par plus
accrued interest to the borrower upon a change in control.
Solution Approach
Step 1 Identify the Host Contract
Step 2 Identify all provisions to be evaluated as derivative instruments
Step 3 Evaluate each provision to determine whether it is clearly and closely related to the host
contract.Step 4 Determine whether the hybrid instrument is remeasured at fair value.
Step 5 - Determine whether a separate instrument with the same terms as the embedded
derivative instrument would, pursuant to Section 815-10-15, be a derivative instrument.
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Example - Debt Host
Step 1 Identify the host contract
The host contract in this example is the Debt Instrument.
Step 2 Identify all provisions to be evaluated as derivative instruments
The following features should be evaluated as derivative instruments:
Conversion Feature
Put Feature
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Example - Debt Host
Step 3 Evaluate each feature to determine whether it is clearly and closely related to the hostcontract.
Conversion Feature
The conversion feature in this example is not clearly and closely related to the host contract. Theequity conversion feature has equity price risk whereas the debt host has interest rate risk.
Put Feature
ASC 815-15-25-40 through 25-42 provides a four-step process to determine whether a put or callis clearly and closely related to the host: (1) the payoff upon settlement is adjusted based onchanges in an index (rather than being simply the repayment of principal at par and accruedinterest), (2) the payoff is indexed to an underlying other than market interest rates or theobligors creditworthiness, (3) the debt involves a substantial premium or discount, and (4) the
call or put is contingently exercisable. For calls and puts as well as contingently exercisable callsand puts to be considered clearly and closely related, they can be indexed only to interest rates orcredit risk, not some extraneous event or factor. As this debt was issued at a substantial discountand the put feature is contingently exercisable, the put is not considered clearly and closelyrelated to the debt host.
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Example - Debt Host
Step 4 Determine whether the hybrid instrument is remeasured at Fair Value.
The hybrid instrument is not remeasured at fair value.
Step 5 - Determine whether a separate instrument with the same terms as the embeddedderivative would, pursuant to Section 815-10-15, be a derivative instrument.
Conversion Feature
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 ornot a settlement is required:
1. One or more underlyings2. One or more notional amounts or payment provisions or both
Conclusion: The conversion feature has an underlying (stock price) and a notional amount($10,000,000).
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Example - Debt Host
b. Initial net investment. The contract requires no initial net investment or an initial netinvestment that is smaller than would be required for other types of contracts that would beexpected to have a similar response to changes in market factors.
Conclusion: This contract requires no initial net investment.
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 substantiallydifferent from net settlement.
Conclusion: This contract requires settlement via delivery of an asset (ABCs stock), however, asABC is not publicly traded, there is no active market for ABCs stock. As such, delivery puts therecipient in a position substantially different from net settlement because the asset is not readilyconvertible into cash. This feature does not meet the definition of a derivative and thereforebifurcation is not required. This feature should be re-evaluated if ABCs stock becomes publiclytraded.
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Example - Debt Host
Put Feature
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
Conclusion: The Put feature has an underlying (change in control) and a payment provision,
therefore it meets this criteria.
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Example - Debt Host
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.
Conclusion: This contract requires no initial net investment.
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.
Conclusion: ASC 815-10-15-107 states that the settlement of a put or call in either publicly or
non-publicly traded debt instruments meets the net settlement criterion because neither party is
required to deliver an asset that is associated with the underlying.
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Contact Info
Padanaram Consulting Group, LLC
Greater New York City AreaPhone: 617.306.0951
Fax: 617.939.0272
www.padanaramconsulting.com
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