5.4 Features Indexed to Inflation in a Debt Host
5.4.1 Background
This section discusses the analysis of whether an inflation-indexed payment
feature embedded in a debt host contract should be separated as a derivative
(e.g., inflation-linked bonds). The discussion does not address features that
could accelerate the repayment of the outstanding amount of the debt in cash
upon the occurrence or nonoccurrence of a specified event (e.g., an acceleration
feature that is triggered by a specified measure of inflation). Such features
should be evaluated as contingent redemption features (see Section 6.4).
5.4.2 Bifurcation Analysis
The table below presents an overview of the bifurcation analysis of an
inflation-indexed payment feature embedded in a debt host contract. However, an
entity should always consider the terms and conditions of a specific feature in
light of all the relevant accounting guidance before reaching a conclusion.
|
Bifurcation Condition
|
Condition Met?
| Analysis |
|---|---|---|
|
Not clearly and closely related (see Section
4.3.2)
|
It depends
|
The rate of inflation in the economic environment for the
currency in which the debt is denominated is clearly and
closely related to the debt host unless the feature is
leveraged (see Section 4.4.2.3). The
rate of inflation in other economic environments is not
clearly and closely related to a debt host.
|
|
Hybrid instrument not measured at fair value through earnings
on a recurring basis (see Section
4.3.3)
|
It depends
|
From the issuer’s perspective, debt is not measured at fair
value on a recurring basis unless the issuer elects the fair
value option in ASC 815-15 or ASC 825-10. The fair value
option cannot be elected for debt that contains a separately
recognized equity component at inception.
From the holder’s perspective, if a loan or debt security is
remeasured at fair value, with changes in fair value
recorded in earnings, any derivative embedded in the
interest would not need to be accounted for separately since
the accounting for the interest would already be the same as
that of a freestanding derivative.
|
|
Meets the definition of a derivative (see Section
4.3.4)
|
Yes
|
An inflation-indexed payment feature that adjusts the
payments of a debt host contract meets the definition of a
derivative (see Section 4.4.2.4).
|
|
Meets a scope exception (see Chapter 2 and Section
4.3.5)
|
No
|
No specific scope exception is available for
inflation-indexed payment features embedded in debt host
contracts (see Section 4.3.5).
|
As shown in the table above, an entity’s determination of whether an
inflation-indexed feature that could adjust the payments of a debt host contract
must be bifurcated as a derivative tends to focus on whether the feature is
considered clearly and closely related to the debt host contract unless the entity
is remeasuring the hybrid instrument at fair value on a recurring basis through
earnings. Typically, such features meet the definition of a derivative and are not
exempt from the scope of derivative accounting.
5.4.3 Clearly-and-Closely-Related Analysis
ASC 815-15
25-50 The
interest rate and the rate of inflation in the economic
environment for the currency in which a debt instrument is
denominated shall be considered to be clearly and closely
related. Thus, nonleveraged inflation- indexed contracts
(debt instruments, capitalized lease obligations, pension
obligations, and so forth) shall not have the
inflation-related embedded derivative separated from the
host contract.
Under ASC 815-15-25-50, the indexation of principal or interest payments to an
inflation rate (e.g., U.S. CPI or U.K. retail price index) is considered clearly and
closely related to a debt host contract if (1) the inflation rate is appropriate for
the economic environment for the currency in which the debt is denominated and (2)
the feature is not leveraged (e.g., interest payments that are computed on the basis
of two times CPI would not be considered clearly and closely related to a debt host
contract). For example, payments indexed to an unleveraged measure of U.S. CPI would
be considered clearly and closely related to USD-denominated debt. Conversely, the
rate of inflation in a different economic environment (e.g., EUR-denominated debt
that has principal or interest payments indexed to U.S. CPI) is not clearly and
closely related to the debt host.
Example 5-10
Debt With Embedded Inflation Index Feature
A U.S. company issues USD-denominated bonds. On the basis of
an embedded inflation index, the bond issuer is required to
pay the change in the Mexican CPI every two years. The
embedded inflation-indexed derivative is not clearly and
closely related to the bond because it is not the rate of
inflation of the United States, the economic environment in
which the bond was issued. However, if the bond issuer was
required to pay the change in U.S. CPI every two years, the
embedded derivative would be clearly and closely related
and, therefore, would not need to be accounted for
separately.
ASC 815-15
Case N: Inflation Bond
55-202 An
inflation bond has a contractual principal amount that is
indexed to the inflation rate but cannot decrease below par;
the coupon rate is typically below that of traditional bonds
of similar maturity.
55-203 An
inflation bond can be viewed as a fixed-rate bond for which
a portion of the coupon interest rate has been exchanged for
a conditional exchange contract (or option contract) indexed
to the consumer price index, or other index of inflation in
the economic environment for the currency in which the bond
is denominated, that entitles the investor to payment of
additional principal based on increases in the referenced
index. Such rates of inflation and interest rates on the
debt instrument are considered to be clearly and closely
related. Therefore, the embedded derivative should not be
separated from the host contract.
5.4.4 Derivative Analysis
The table below presents an analysis of whether an inflation-indexed
feature that could adjust the cash flows of a debt host contract meets the
definition of a derivative (see Section 4.3.4). However, an entity should always consider the terms
and conditions of a specific feature in light of the applicable accounting guidance
before reaching a conclusion.
|
Characteristics of a Derivative
|
Characteristic Present?
|
Analysis
|
|---|---|---|
|
Underlying and notional amount or payment provision (see
Section 1.4.1)
|
Yes
|
An inflation-indexed payment feature that could adjust the
payments of a debt host contract has both an underlying
(i.e., the applicable measure of inflation, such as the
change in CPI) and a notional amount (i.e., the amount on
which the adjustment is based, such as the debt’s
outstanding amount) or payment provision (e.g., a fixed cash
payment).
|
|
Initial net investment (see Section
1.4.2)
|
Yes
|
The initial net investment in an embedded feature is its fair
value (i.e., the amount that would need to be paid to
acquire the inflation-indexed feature on a stand-alone basis
without the host contract). Generally, an inflation-indexed
feature has an initial net investment that is smaller than
would be required for a direct investment that has the same
exposure to changes in the inflation rate (since the
investment in the debt host contract does not form part of
the initial net investment for the embedded feature).
|
|
Net settlement (see Section 1.4.3)
|
Yes
|
A feature that adjusts the payments of a debt host contract
on the basis of an inflation index meets the net settlement
condition (neither party is required to deliver an asset
that is associated with the underlying and whose principal
amount, stated amount, face value, number of shares, or
other denomination is equal to the feature’s notional
amount).
|
As shown in the table above, an inflation-indexed feature embedded in a debt host
contract typically meets the definition of a derivative. Therefore, the analysis of
whether such a feature must be bifurcated as a derivative tends to focus on whether
the feature is considered clearly and closely related to the debt host contract
unless the entity is remeasuring the hybrid instrument at fair value on a recurring
basis through earnings.