8.1 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.
Although outstanding debt instruments typically do not meet the definition of a
derivative in their entirety (e.g., they usually lack a derivative’s initial net
investment characteristic; see Section 8.3.4.3), the
contractual terms of debt arrangements may include one or more embedded features
that could affect the cash flows, values, or other exchanges required by the terms
in a manner similar to a derivative. An entity is required to evaluate such features
to determine whether they must be accounted for separately from their host debt
contract as derivative instruments under ASC 815 (see Section 8.4).
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 in the contractual terms of nonderivative
contracts (e.g., outstanding debt). 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 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.
Not all embedded features need to be bifurcated from their host
contracts. For example, entities should not bifurcate features that:
- Would not have met the definition of a derivative in ASC 815 on a freestanding basis (see Section 8.3.4) or that qualify for a derivative accounting scope exception (see Section 8.3.5).
- 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 (see Section 8.3.3).
- Have economic characteristics and risks that are clearly and closely related to those of their host contract.
Accordingly, a debtor must carefully evaluate the terms of outstanding debt
arrangements to determine whether they contain any features that must be accounted
for as derivatives separately from their debt host contracts under ASC 815-15.
Examples of such terms include:
-
Interest payments that are leveraged or inversely related to market interest rates or are subject to a collar, cap, or floor (see Section 8.4.1).
-
The holder’s right to require the issuer to repay the outstanding amount before the stated maturity date (i.e., a put or redemption option; see Section 8.4.4).
-
The issuer’s right to prepay the stated amount (i.e., a call option; see Section 8.4.4).
-
Terms that accelerate the repayment of principal or interest upon the occurrence or nonoccurrence of an event (e.g., an event of default, a change of control, or an IPO; see Section 8.4.4).
-
Term extension features (see Section 8.4.5).
-
A right or obligation to convert the instrument into the debtor’s equity instruments (e.g., common or preferred stock), including a right or obligation that is contingent on the occurrence of a specified event (e.g., debt that is mandatorily convertible into the issuer’s equity shares upon an IPO; see Section 8.4.7).
-
Foreign currency features (see Section 8.4.8).
-
Payments that are triggered upon the occurrence or nonoccurrence of an event that is unrelated to an interest rate index or the issuer’s credit risk (e.g., late filings; see Section 8.4.11).
This chapter provides an overview of the derivative separation requirements that
apply to embedded features in debt instruments.