Accounting for Embedded Derivatives

8/4/2019 Accounting for Embedded Derivatives

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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

substantially different from net settlement. 4


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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.


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.


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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Accounting for Embedded Derivatives

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