A.7 Application of the Double-Double Test in ASC 815
When evaluating whether an embedded derivative in which the only underlying is an interest rate or interest rate index (i.e., an interest rate-related underlying) is clearly and closely related to its interest-bearing host, an entity must apply the test established by ASC 815-15-25-26(b) (i.e., the double-double test). The double-double test consists of two tests that are performed on the date on which the instrument is acquired (or incurred) by the reporting entity.
In the first of the two tests, the entity that performs the evaluation must determine whether there is a possible future interest rate scenario, no matter how remote, in which the embedded derivative would at least double the investor’s initial rate of return on the host contract. In making this assessment, the entity must differentiate the return on the host contract from the return on the hybrid contract. The host contract excludes the effects of the embedded derivative. If an embedded derivative does not pass this test, it would be considered clearly and closely related to its host (provided that it does not meet the condition in ASC 815-15-25-26(a)). If the embedded derivative does pass this test, the entity must perform a second test to determine whether it is clearly and closely related to the host contract.
In the second test, the entity must determine whether, for any of the scenarios identified in the first test for which the investor’s initial rate of return on the host contract would be doubled, the embedded derivative would at the same time result in a rate of return that (1) is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and (2) involves a debtor with a credit quality similar to that of the issuer’s at inception. If the embedded derivative also passes this test, it would not be considered clearly and closely related to its host contract.
If the second test is not passed (and the embedded derivative does not meet the condition in ASC 815-15-25-26(a)), the embedded derivative would be considered clearly and closely related to the host contract.
Example A-4
Bond With Interest Rate Cap Provision
On January 1, 20X1, Company A purchases a bond at par that pays LIBOR. The bond also incorporates an interest rate cap provision stating that A will receive a return of 10 percent if LIBOR equals or exceeds 8 percent as of any interest rate reset date. On the date A purchases the bond, it also could purchase at par a variable-rate bond that does not contain a cap and that pays LIBOR minus 1 percent from a debtor with the same credit quality as the issuer of A’s bond. As of January 1, 20X1, LIBOR is 5 percent. The bond cannot contractually be settled in a manner in which A would not recover substantially all of its initial recorded investment in the bond. To perform the first test in ASC 815-15-25-26(b), A must determine whether there is any interest rate scenario, no matter how remote, under which the embedded derivative (the cap) would at least double its initial rate of return on the host contract. This analysis is summarized in the following table:
Because the first test has been satisfied, A must perform the second test in ASC 815-15-25-26(b) to determine whether the embedded cap is clearly and closely related to its bond host. In this test, A must determine, for any of the possible interest rate scenarios identified above under which A’s initial rate of return on the host contract would be doubled, whether the embedded cap would simultaneously result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and involves a debtor with a credit quality similar to that of the issuer’s at inception. Company A’s analysis for this test can be summarized as follows:
Since both of the ASC 815-15-25-26(b) tests are not met, the embedded cap is considered clearly and closely related to the bond host.