4.1 Background
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.
As noted in Section 1.3, an instrument that does not meet the
definition of a derivative in its entirety may contain contractual terms or features
that affect the cash flows, values, or other exchanges required by the terms of the
instrument in a manner similar to a derivative. Such contractual terms or features
are “embedded” in the instrument or contract and are referred to as “embedded
derivatives,” as defined in the ASC master glossary. Embedded derivatives that meet
all of the requirements for bifurcation are accounted for separately from their host
contract as if they were freestanding derivatives; that is, they are recorded at
fair value at the end of each reporting period, with changes in fair value generally
reported through earnings.
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 in the contractual terms of nonderivative
contracts (e.g., outstanding debt, preferred stock). Accordingly, it decided that
derivatives that are embedded in the terms of nonderivative contracts should be
accounted for as derivatives separately from the contracts in which they are
embedded (i.e., host contracts) when certain criteria are met. 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 other
contract.
The FASB also decided that not all embedded features need to be bifurcated from their
host contracts. Features that would not have met the definition of a derivative in
ASC 815 on a freestanding basis (see Section 4.3.4) or that
qualify for a derivative accounting scope exception (see Section
4.3.5) should not be bifurcated. Features that are embedded in
contracts that are accounted for in their entirety at fair value, with changes in
fair value recognized in earnings on a recurring basis, are also not bifurcated (see
Section 4.3.3). Further, features that have economic
characteristics and risks that are clearly and closely related to those of their
host contract are not bifurcated.
Accordingly, an entity must carefully evaluate the terms of outstanding hybrid
instruments to determine whether they contain any features that must be accounted
for as derivatives separately from their host contracts under ASC 815-15.
This chapter includes guidance on how to (1) identify embedded features, (2) evaluate
whether those features require bifurcation, and (3) account for bifurcated embedded
derivatives.