We recently released two new online eLearning courses related to the accounting for derivatives and embedded derivatives in accordance with ASC 815. It’s part of our ongoing initiative to expand the course catalog on our online learning platform, the Revolution. As part of this process, we realized that we had published very few blogs related to derivatives and embedded derivatives. What?!

I was shocked as it is one of my favorite topics to teach. It’s also the one that when my wife has trouble falling asleep, she asks me, “Honey, talk to me about derivatives.” In this post, we’ll talk about identifying and accounting for embedded derivatives, and I’ll try not to put you to sleep!

ASC 815 defines an embedded derivative as follows:

Implicit or explicit terms that affect some or all of the cash flows or the values of other exchanges required by a contract in a manner similar to a derivative instrument.

Embedded derivatives “live” within hybrid instruments. A hybrid instrument is a contract that contains both an embedded derivative and a host contract. The big issue with hybrid instruments is determining whether the instrument should be “bifurcated” (i.e. recording the host contract and the embedded derivative separately and applying U.S. GAAP to each) or remain as one instrument for valuation and accounting purposes (i.e. applying U.S. GAAP to the entire hybrid instrument).

If the embedded derivative must be separated from the host contract, then the embedded derivative should be recorded separately on the balance sheet at fair value, with any changes in fair value immediately recorded in earnings (unless it is part of qualified hedging transaction). Meanwhile, the host instrument would be accounted for under “normal” GAAP.

At issuance or acquisition of a hybrid instrument, we must determine whether or not we need to separately account for an embedded derivative. This analysis requires significant judgment and is an ongoing process as long as we hold the hybrid instrument. The only exception relates to hybrid instruments that have foreign currency embedded derivatives, which are assessed only at inception. We’ve summarized these considerations into three easy steps as illustrated in the slide above.

Let’s take a look at each step using the following example:

Step 1: Identify the host and embedded derivative of the hybrid instrument

First, we need to identify the host contract, which is generally classified into one of the following types of instruments:

• Debt instruments, including loans and insurance contracts
• Equity instruments
• Lease contracts

This determination is important because it underpins the “clearly and closely related” criterion that will discuss in step 2.

Next, we need to determine whether the embedded feature meets the definition of a derivative based on the characteristics found within ASC 815-10-15-83:

1. Has an underlying and either a notional amount or payment provision;
2. Requires no initial net investment or an initial net investment that is smaller than would be required for other similar types of contracts; and
3. Is able to be settled net.

If there is more than one embedded derivative requiring bifurcation, then ASC 815 requires us to incorporate them into and account for them as a single derivative instrument.

In our example, the host instrument is a 5-year, $100 million note payable, which is a debt instrument. There is a single embedded derivative, which is some sort of swap requiring Sherlock Bank to pay interest based on the DJIA Index instead of interest- and credit-related factors.

Step 2: Determine whether or not the hybrid instrument needs to be separated

To determine whether or not the hybrid instrument needs to be bifurcated (i.e. accounting for the host and embedded derivative separately), we need to answer the following three questions:

Is the contract carried at fair value through earnings?

The whole point of bifurcation is to make sure all derivatives are on the balance sheet at fair value, with any changes in fair value reported in earnings. If the entire hybrid is already carried at fair value through earnings, then any embedded derivative would also be carried at fair value through earnings and bifurcation would not be necessary (and we could stop our analysis).

In our example, a note payable is accounted for at amortized cost. Therefore, we need to continue with our analysis.

Would the embedded feature be a derivative if it was freestanding?

This is a test to make sure the feature you identified as the embedded derivative is a derivative as defined by ASC 815. If it does not meet the definition of a derivative, then it cannot be separated from the host and accounted for as such.

In our example, the embedded feature meets the definition of a derivative because:

1. It has an underlying (DJIA Index) and a notional amount ($100 million).
2. It required no initial net investment (i.e. it did not cost us anything “extra” as it was included in the price of the note payable).
3. Net settlement is explicitly required by the contract (i.e. the interest payments paid in cash and based on the DJIA Index is a form of net settlement).

Therefore, we need to continue our analysis.

Is the embedded derivative “clearly and closely related” to the host contract?

If the underlying of the embedded derivative is “clearly and closely related” to the host contract, then bifurcation is prohibited (i.e. we’d account for the entire hybrid instrument as one instrument).

But, what does it mean to be “clearly and closely related"? I like to think of it as what is “normal” for the host instrument. For debt instruments, if the underlying relates to interest, inflation, or the creditworthiness of the issuer, then that would be considered “normal” and bifurcation would not be required.

However, in our example, the underlying related to an equity index which is not “clearly and closely related” to our debt instrument host. Therefore, bifurcation is required.

Step 3: Determine the valuation of both the embedded derivative and host

Once we’ve determined that bifurcation is required, the hybrid instrument must be split and the various components (i.e. host and embedded derivative) must be valued separately. ASC 815 requires us to use a “with and without method.” Under this method, the fair value of the embedded derivative must be determined first. The difference between the overall value of the hybrid instrument at inception and the fair value of the embedded derivative is the value attributed to the host instrument.

The embedded derivative would continue to be recorded on the balance sheet at fair value, with changes in fair value recorded in earnings, while the host instrument would be accounted for under “normal” GAAP. However, an entity could avoid applying two different accounting methodologies for one instrument by utilizing the fair value option within ASC 825 and accounting for the entire hybrid instrument at fair value through earnings.

In our example, the overall value of the hybrid instrument is the money received at issuance ($85 million). The fair value of the embedded derivatives, on a stand-alone basis, was $3 million. Therefore, the value of the host instrument is the difference ($82 million), not the $80 million as noted in the case. The “with and without method” prevents Sherlock Bank from initially recognizing the structuring fee ($2 million) at issuance, instead requiring them to defer it and recognize it over the life of the note payable using the effective rate method, which is “normal” GAAP for a debt instrument issued by an entity.

Are you still awake? We hope so! If you have any questions regarding this post, accounting for embedded derivatives, or need help training your professionals, we’re always here to help!

Disclaimer  

This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.