1.3 Concept of Embedded Derivatives
ASC 815-15
05-1 Contracts that do not in
their entirety meet the definition of a derivative
instrument (see paragraphs 815-10-15-83 through 15-139),
such as bonds, insurance policies, and leases, may contain
embedded derivatives. The effect of embedding a derivative
instrument in another type of contract (the host contract)
is that some or all of the cash flows or other exchanges
that otherwise would be required by the host contract,
whether unconditional or contingent on the occurrence of a
specified event, will be modified based on one or more
underlyings.
15-2
The guidance in this Subtopic applies only to contracts that
do not meet the definition of a derivative instrument in
their entirety.
A contract that itself does not meet the definition of a derivative in its entirety
may have implicit or explicit terms that affect the cash flows or the value of the
contract in a manner similar to a derivative. Those implicit or explicit terms may
qualify as “embedded derivatives” under the guidance in ASC 815-15. A contract in
which the derivative is embedded is referred to as the “host contract”; when
combined, the host contract and the embedded derivative are referred to as a “hybrid
instrument.”
An embedded feature will only require separate accounting treatment
as a derivative if it meets the following three conditions in ASC 815-15-25-1:
-
The embedded derivative is “not clearly and closely related” to the host contract (see Section 4.3.2).
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The instrument is not subject to recurring fair value measurement, with changes in fair value recorded through earnings (see Section 4.3.3).
-
The embedded derivative would meet the definition of a derivative within the scope of ASC 815 if it were issued on a freestanding (stand-alone) basis (see Section 1.4).
In developing the derivative accounting requirements that are now located in ASC 815
(such as the requirement to measure derivatives at fair value on a recurring basis),
the FASB concluded that an entity should not be able to circumvent those
requirements by incorporating derivatives into the contractual terms of
nonderivative contracts (e.g., outstanding debt or equity). Accordingly, it decided
that when certain criteria are met (described above), derivatives embedded in the
terms of nonderivative contracts should be accounted for as derivatives separately
from the contracts in which they are embedded. An entity is thus unable to avoid the
recognition and measurement requirements of ASC 815 merely by embedding a derivative
instrument in a nonderivative financial instrument or another contract.