1.6 Unit of Account
ASC 815-10
Viewing a Contract as Freestanding or Embedded
15-5
The notion of an embedded derivative, as discussed in
paragraph 815-15-25-1, does not contemplate features that
may be sold or traded separately from the contract in which
those rights and obligations are embedded. Assuming they
meet this Subtopic’s definition of a derivative instrument,
such features shall be considered attached freestanding
derivative instruments rather than embedded derivatives by
both the writer and the current holder.
15-6 A
put or call option that is added or attached to a debt
instrument by a third party contemporaneously with or after
the issuance of the debt instrument shall be separately
accounted for as a derivative instrument under this Subtopic
by the investor (that is, by the creditor). An option that
is added or attached to an existing debt instrument by
another party results in the investor having different
counterparties for the option and the debt instrument and,
thus, the option shall not be considered an embedded
derivative. Paragraph 815-15-25-2 states that notion of an
embedded derivative in a hybrid instrument refers to
provisions incorporated into a single contract, and not to
provisions in separate contracts between different
counterparties.
15-7
If a debt instrument includes in its terms at issuance an
option feature that is explicitly transferable independent
of the debt instrument and thus is potentially exercisable
by a party other than either the issuer of the debt
instrument (the debtor) or the holder of the debt instrument
(the investor), that option shall be considered under this
Subtopic as an attached freestanding derivative instrument,
rather than an embedded derivative, by both the writer and
the holder of the option.
Viewing Two or More Contracts as a Unit in Applying the Scope
of This Subtopic
15-8
In some circumstances, an entity could enter into two or
more legally separate transactions that, if combined, would
generate a result that is economically similar to entering
into a single transaction that would be accounted for as a
derivative instrument under this Subtopic. For guidance on
circumstances in which two or more contracts that have been
determined to be derivative instruments within the scope of
this Subtopic must be viewed as a unit, see the guidance
beginning in paragraph 815-10-25-6. For guidance on
circumstances in which two or more contracts that have been
determined to be options within the scope of this Subtopic
must be viewed in combination, see the guidance beginning in
paragraph 815-10-25-7.
15-9
If two or more separate transactions may have been entered
into in an attempt to circumvent the provisions of this
Subtopic, the following indicators shall be considered in
the aggregate and, if present, shall cause the transactions
to be viewed as a unit and not separately:
- The transactions were entered into contemporaneously and in contemplation of one another.
- The transactions were executed with the same counterparty (or structured through an intermediary).
- The transactions relate to the same risk.
- There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.
A Transferable Option Is Considered Freestanding, Not
Embedded
55-3
Certain structured transactions involving the issuance of a
bond incorporate transferable options to call or put the
bond. As such, those options are potentially exercisable by
a party other than the debtor or the investor. For example,
certain put bond structures involving three separate parties
— the debtor, the investor, and an investment bank — may
incorporate options that are ultimately held by the
investment bank, giving that party the right to call the
bond from the investor. For example, a call option that is
transferable either by the debtor to a third party and thus
is potentially exercisable by a party other than the debtor
or by the original investor based on the legal agreements
governing the debt issuance can result in the investor
having different counterparties for the option and the
original debt instrument. Accordingly, even if incorporated
into the terms of the original debt agreement, such an
option may not be considered an embedded derivative by
either the debtor or the investor because it can be
separated from the bond and effectively sold to a third
party.
In the application of ASC 815, the unit of account is typically an
individual contract or an embedded feature within a contract. Unless a scope
exception applies, both freestanding derivative instruments and embedded derivative
components must be accounted for as derivatives under ASC 815. It is important to
identify whether a feature is embedded or freestanding because the incremental
guidance in ASC 815-15 affects whether an embedded feature requires separate
accounting recognition.
ASC 815-10-15-7 notes that if, upon issuance, an instrument includes
“an option feature that is explicitly transferable independent of the debt
instrument and thus is potentially exercisable by a party other than either the
issuer [or] holder,” both the option writer and holder should treat the option as a
freestanding derivative attached to the instrument instead of a derivative embedded
in the instrument. As noted in ASC 815-10-15-6, a “put or call option that is added
or attached . . . by a third party [either] contemporaneously with or after
[initial] issuance of the debt instrument” is an example of an attached feature that
is considered freestanding.
As indicated in ASC 815-10-15-8, there may be circumstances in which an entity enters
into legally separate transactions “that, if combined, would generate a result that
. . . would be accounted for as a derivative instrument” under ASC 815. ASC 815-10
contains additional guidance to help an entity determine whether two or more
separate transactions should be viewed as separate units of account or combined for
accounting purposes.
Nevertheless, ASC 815 ordinarily does not permit an entity to treat two or more
freestanding financial instruments as a single combined unit of account. DIG Issue
F6 (not codified) notes the following:
[ASC 815] is a transaction-based
standard.
Similarly, ASC 815-10-25-6 states, in part:
[ASC 815-10] generally does not
provide for the combination of separate financial instruments to be evaluated as
a unit.
However, if two or more freestanding financial instruments have characteristics
suggesting that they were structured to circumvent GAAP, they may need to be
combined and treated as a single unit of account. Specifically, ASC 815-10 requires
two or more separate transactions to be combined and viewed in combination as a
single unit of account if they were entered into in an attempt to circumvent the
accounting requirements for derivatives (i.e., measured at fair value, with
subsequent changes in fair value recognized in earnings except for qualifying
hedging instruments in cash flow or net investment hedges). ASC 815-10-15-9 states
that such combination is required if the transactions have all of the following
characteristics:
- They “were entered into contemporaneously and in contemplation of one another.”
- They “were executed with the same counterparty (or structured through an intermediary).”
- They “relate to the same risk” (e.g., the fair value of the issuer’s equity shares).
- “There is no apparent economic need or substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.”
ASC 815-10-25-6 identifies characteristics similar to those listed above from ASC
815-10-15-98 and adds the following commentary:
If separate derivative
instruments have all of [these] characteristics, judgment shall be applied to
determine whether the separate derivative instruments have been entered into in
lieu of a structured transaction in an effort to circumvent GAAP: . . . If such
a determination is made, the derivative instruments shall be viewed as a
unit.
ASC 815 does not specify a period of separation between transactions (e.g., one day,
one week) that would disqualify them from being treated as contemporaneous. A
one-week period between transactions may be sufficient evidence that the
transactions are not contemporaneous if the entity is exposed to market fluctuations
during this time. Thus, even when transactions occur at different times, entities
must consider all available evidence to ensure that no side agreements or other
contracts were entered into that call into question whether the transactions were
contemporaneous (e.g., there are no earlier agreements for trades to be entered into
simultaneously).
In the implementation guidance below, the FASB illustrates the unit of account
concepts:
- Example 1 in ASC 815-10-55-66 through 55-72 shows whether an attached (Case A) or transferable (Case B) call feature should be seen as a freestanding or embedded feature.
- Example 18 in ASC 815-10-55-171 through 55-174 and Example 19 in ASC 815-10-55-175 through 55-180 illustrate how to determine whether two transactions should be combined.
ASC 815-10
Example 1: Viewing a Contract as Freestanding or
Embedded
55-66 The following
Cases illustrate the application of paragraph 815-10-15-6:
- Attached call option (Case A)
- Transferable call option (Case B).
Case A: Attached Call Option
55-67 This Case
presents a transaction that involves the addition of a call
option contemporaneously with or after the issuance of
debt.
55-68 Entity X issues
15-year puttable bonds to an Investment Banker for $102. The
put option may be exercised at the end of five years.
Contemporaneously, the Investment Banker sells the bonds
with an attached call option to Investor A for $100. (The
call option is a written option from the perspective of
Investor A and a purchased option from the perspective of
the Investment Banker.) The Investment Banker also sells to
Investor B for $3 the call option purchased from Investor A
on those bonds. The call option has an exercise date that is
the same as the exercise date on the embedded put option. At
the end of five years, if interest rates increase, Investor
A would presumably put the bonds back to Entity X, the
issuer. If interest rates decrease, Investor B would
presumably call the bonds from Investor A.
55-69 As required by
paragraph 815-10-15-6, the call option that is attached by
the Investment Banker is a separate derivative instrument
from the perspective of Investor A.
Case B: Transferable Call Option
55-70 This Case
presents a group of transactions with a similar overall
effect to that in Case A.
55-71 Entity Y issues
15-year puttable bonds to Investor A for $102. The put
option may be exercised at the end of five years.
Contemporaneously, Entity Y purchases a transferable call
option on the bonds from Investor A for $2. Entity Y
immediately sells that call option to Investor B for $3. The
call option has an exercise date that is the same as the
exercise date of the embedded put option. At the end of five
years, if rates increase, Investor A would presumably put
the bonds back to Entity Y, the issuer. If rates decrease,
Investor B would presumably call the bonds from Investor
A.
55-72 As required by
paragraph 815-10-15-6, the call option is a separate
freestanding derivative instrument that must be reported at
fair value with changes in value recognized currently in
earnings unless designated as a hedging instrument.
Example 18: Recognition — Viewing Separate Transactions
as a Unit
55-171 The following
Cases illustrate when separate transactions should be viewed
as a unit:
- Swaps that should be viewed as a unit (Case A)
- Swaps that should not be viewed as a unit (Case B).
55-172 In Cases A and
B, an entity that is the issuer of fixed-rate debt enters
into an interest rate swap (Swap 1) and designates it as a
hedge of the fair value exposure of the debt to interest
rate risk. The fair value hedge of the fixed-rate debt
involving Swap 1 meets the required criteria in Section
815-20-25 to qualify for hedge accounting. The entity
simultaneously enters into a second interest rate swap (Swap
2) with the same counterparty with the exact mirror terms as
Swap 1 and does not designate Swap 2 as part of that hedging
relationship.
Case A: Swaps That Should Be Viewed as a Unit
55-173 If Swap 2 was
entered into in contemplation of Swap 1 and the overall
transaction was executed for the sole purpose of obtaining
fair value accounting treatment for the debt, it should be
concluded that the purpose of the transaction was not to
enter into a bona fide hedging relationship involving Swap
1. In that instance, the two swaps should be viewed as a
unit and the entity would not be permitted to adjust the
carrying value of the debt to reflect changes in fair value
attributable to interest rate risk.
Case B: Swaps That Should Not Be Viewed as a Unit
55-174 If Swap 2 was
not entered into in contemplation of Swap 1 or there is a
substantive business purpose for structuring the
transactions separately, and if both Swap 1 and Swap 2 were
entered into in arm’s-length transactions (that is, at
market rates), then the swaps should not be viewed as a
unit. For example, some entities have a policy that requires
a centralized dealer subsidiary to enter into third-party
derivative contracts on behalf of other subsidiaries within
the entity to hedge the subsidiaries’ interest rate risk
exposures. The dealer subsidiary also enters into internal
derivative contracts with those subsidiaries to
operationally track those hedges within the entity. (As
discussed beginning in paragraph 815-20-25-61, internal
derivatives do not qualify in consolidated financial
statements as hedging instruments for risks other than
foreign exchange risk.)
Example 19: Recognition — Viewing Separate Transactions
as a Unit for Purposes of Evaluating Net
Settlement
55-175 The following
Cases illustrate the guidance in paragraphs 815-10-15-8
through 15-9 on whether separate transactions should be
viewed as a unit for purposes of evaluating the
characteristic of net settlement:
- Two forward contracts viewed as a unit (Case A)
- Borrowing and lending transactions viewed as a unit (Case B).
55-176 In Cases A and
B, the transactions were entered into with the same
counterparty, were executed simultaneously, and relate to
the same risk.
Case A: Two Forward Contracts Viewed as a Unit
55-177 Entity A enters
into a forward contract to purchase 1,500,000 units of a
particular commodity in 3 months for $10 per unit.
Simultaneously, Entity A enters into a forward contract to
sell 1,400,000 units of the same commodity in 3 months for
$10 per unit. The purchase and sale contracts are with the
same counterparty. There is no market mechanism to
facilitate net settlement of the contracts, and both
contracts require physical delivery of the commodity at the
same location in exchange for the forward price. On a gross
basis, neither contract is readily convertible to cash
because the market cannot rapidly absorb the specified
quantities without significantly affecting the price.
However, on a net basis, Entity A has a forward purchase
contract for 100,000 units of the commodity, a quantity that
can be rapidly absorbed by the market and thus is readily
convertible to cash.
55-178 In this Case, it
appears that there is no clear business purpose for
structuring the transactions separately. Therefore, the
facts point to the conclusion that the purchase and sale
were done as a structured transaction with one counterparty
to circumvent the definition of a derivative instrument
under this Subtopic. However, if the facts indicated that
both contracts required physical delivery of the commodity
at different locations that are significantly distant from
one another and each counterparty is expected to deliver the
gross amount of the commodity to the other, those facts may
reflect a valid substantive business purpose for the
transaction.
Case B: Borrowing and Lending Transactions Viewed as a
Unit
55-179 Entity C loans
$100 to Entity B. The loan has a 5-year bullet maturity and
an 8 percent fixed interest rate, payable semiannually.
Entity B simultaneously loans $100 to Entity C. The loan has
a five-year bullet maturity and a variable interest of
LIBOR, payable semiannually and reset semiannually. Entity B
and Entity C enter into a netting arrangement that permits
each party to offset its rights and obligations under the
agreements. The netting arrangement meets the criteria for
offsetting in Subtopic 210-20. The net effect of offsetting
the contracts for both Entity B and Entity C is the economic
equivalent of an interest rate swap arrangement, that is,
one party receives a fixed interest rate from, and pays a
variable interest rate to, the other.
55-180 In this Case,
based on the facts presented, there is no clear business
purpose for the separate transactions, and they should be
accounted for as an interest rate swap under this Subtopic.
However, in other instances, a clear substantive business
purpose for entering into two separate loan transactions may
exist (for example, as a means to overcome foreign currency
expatriation restrictions).
Note that the SEC staff has indicated that it will challenge the
accounting for transactions that have been structured to circumvent GAAP. EITF Issue
02-2 (not codified) states, in part:
The SEC Observer
encouraged the [FASB] to examine the broader issue of when to combine
transactions and noted that, in the interim, the SEC staff will continue to
challenge the accounting for transactions for which it appears that multiple
contracts have been used to circumvent generally accepted accounting
principles.
ASC 815-10
Viewing Combinations of Options as Separate Options or
as a Single Forward Contract
25-7
This guidance addresses a combination of two options — one
that is a purchased call (put) option and another that is a
written put (call) option — having all of the following
characteristics:
- They have the same strike price, notional amount, and exercise date.
- They have the same underlying.
- Neither is required to be exercised.
25-8
The guidance addresses such options in two contexts:
- Combinations of two freestanding options or a freestanding and embedded option
- Combinations of two embedded options.
25-9
Derivative instruments that are transferable are, by their
nature, separate and distinct contracts. Accordingly, a
separate freestanding purchased call (put) option and
written put (call) option with all of the characteristics in
paragraph 815-10-25-7 convey rights and obligations that are
distinct whether involving the same or different
counterparties and do not warrant bundling as a single
forward contract for accounting purposes under this Subtopic
by any party to the contracts. (The separate purchased
option and written option can be viewed in combination and
jointly designated as the hedging instrument pursuant to
paragraph 815-20-25-45.)
Combinations of Two Freestanding Options or a Freestanding
and Embedded Option
25-9A
A combination of a freestanding purchased call (put) option
and a freestanding or embedded (nontransferable) written put
(call) option shall be considered for accounting purposes as
separate option contracts, rather than a single forward
contract, by both parties to the contracts even though all
of the following conditions are met:
- The options have the same terms.
- The options have the same underlying.
- The options are entered into contemporaneously with the same counterparty at inception.
25-9B
Both a combination of a freestanding purchased call (put)
option and a freestanding or embedded (nontransferable)
written put (call) option and a combination of a
freestanding written call (put) option and an embedded
(nontransferable) purchased put (call) option shall be
considered for accounting purposes as separate option
contracts, rather than a single forward contract, by both
parties to the contracts even though all of the following
conditions are met:
- The options have the same terms.
- The options have the same underlying.
- The options are entered into contemporaneously with different counterparties at inception.
Combinations of Two Embedded Options
25-10
A combination of an embedded (nontransferable) purchased
call (put) option and an embedded (nontransferable) written
put (call) option in a single hybrid instrument with all of
the characteristics in paragraph 815-10-25-7 and that are
entered into contemporaneously with the same counterparty
shall be considered as a single forward contract for
purposes of applying the provisions of this Subtopic. The
notion of the same counterparty encompasses contracts
entered into directly with a single counterparty and
contracts entered into with a single party that are
structured through an intermediary. (Note that a share of
stock being puttable by the holder and callable by the
issuer under the same terms does not render the stock
mandatorily redeemable under the provisions of Topic 480.)
Topic 480 requires that mandatorily redeemable financial
instruments be classified as liabilities.
25-11
The embedded options are in substance an embedded forward
contract because they meet both of the following conditions:
- They convey rights (to the holder) and obligations (to the writer) that are equivalent from an economic and risk perspective to an embedded forward contract.
- They cannot be separated from the hybrid instrument in which they are embedded.
25-12
Even though neither party is required to exercise its
purchased option, the result of the overall structure is a
hybrid instrument that will likely be redeemed at a point
earlier than its stated maturity. That result is expected by
both the hybrid instrument’s issuer and investor regardless
of whether the embedded feature that triggers the redemption
is in the form of two separate options or a single forward
contract.
25-13
However, if either party is required to exercise its
purchased option before the stated maturity date of the
hybrid instrument, the hybrid instrument shall not be viewed
for accounting purposes as containing one or more embedded
derivatives. In substance, the debtor (issuer) and creditor
(investor) have agreed to terms that accelerate the stated
maturity of the hybrid instrument and the exercise date of
the option is essentially the hybrid instrument’s actual
maturity date. As a result, it is inappropriate to
characterize the hybrid instrument as containing either of
the following:
- Two embedded option contracts that are exercisable only on the actual maturity date
- An embedded forward contract that is a combination of an embedded purchased call (put) and a written put (call) with the same terms.
In each of the scenarios contemplated by the guidance in ASC 815-10-25-7 through
25-13, both the purchased call (put) option and the written call (put) option have
the same strike price, notional amount, exercise date, and underlying, and neither
option is required to be exercised. To ascertain whether options must be bundled as
a single forward contract for accounting purposes under ASC 815, an entity must
determine whether they are freestanding or embedded:
- A “freestanding purchased call (put) option and written put (call) option with all of the characteristics in paragraph 815-10-25-7 convey [distinct] rights and obligations [regardless of whether the counterparties are] the same or different . . . and do not warrant bundling as a single forward contract for accounting purposes” (see ASC 815-15-25-9).
- The combination of two embedded options “that are entered into contemporaneously with the same counterparty shall be considered as a single forward contract for purposes of applying the provisions of [ASC 815]” (see ASC 815-15-25-10).