Accounting for Embedded Derivatives

If you have a debt or equity financial instrument, chances are it has embedded derivatives, which adds another layer of complexity. Even if you think you have straightforward debt, there can be provisions such as an additional interest penalty that are considered embedded derivatives. There are many steps in analyzing financial instruments. Once you identify all the embedded derivatives in the financial instrument, you’ll need to determine if they are required to be bifurcated and accounted for separately. 

Why does it matter?

The provisions related to embedded derivatives are one of the areas that cause companies considerable difficulty. The accounting for derivatives is complex, and there are many judgments involved, especially around the fair value of the derivatives. If the embedded derivative needs to be bifurcated, the fair value analysis needs to be performed every reporting period, with changes in fair value impacting earnings. Companies should have controls in place that assure all new contracts are evaluated for potential embedded derivatives.

What is an embedded derivative? 

An embedded derivative is an implicit or explicit term within a contract that affects some or all the cash flows or the value of other exchanges required by the contract like a derivative instrument. In other words, an embedded derivative is a derivative within another contract that is not a derivative.

Some examples of embedded derivative descriptors include:

• Right to put/call/redeem/repurchase (redemption features)
• Right to prepay/ accelerate repayment/early exercise
• Right to convert (conversion features)
• Right to terminate/extend
• Right to exchange
• Indexed/referenced to
• Pricing based on a formula
• Option/choice between
• Conditional/contingent

Common term loan embedded features include early redemption call options, mandatory repayment upon event of default, mandatory prepayment, default interest rate, and term extension option.

Convertible financial instruments like preferred stock typically have various settlement alternatives, including possible automatic or voluntary conversion to shares based on a discount to the share price paid in a Qualified Financing or Unqualified Financing, possible conversion to shares at a fixed price, and cash settlement upon a corporate transaction.  

What are the financial instruments being analyzed?

The first step in evaluating the accounting for debt and equity instruments is to identify all freestanding financial instruments. Once identified, freestanding financial instruments should be separately analyzed and accounted for, and then evaluated to determine whether embedded features, if any, within those instruments should be bifurcated or accounted for separately. 

In accordance with ASC 480, a freestanding financial instrument is a financial instrument that is entered (1) separately and apart from any other financial instruments or equity transactions or (2) in conjunction with another transaction and is legally detachable and separately exercisable. 

The determination of whether an instrument is freestanding involves understanding both the form and substance of the transaction. The specific agreement in which a term or feature is described is not by itself determinative when evaluating whether that term or feature is considered freestanding. In other words, an instrument is not considered automatically freestanding just because it is documented in a separate contract. Similarly, rights and obligations documented in a single agreement may be treated as separate freestanding instruments. In general, the accounting should follow the contractual terms, not the intent of the parties. However, substantial judgment may be involved.

The following factors should be considered in making this determination: 

• The instruments were issued separately or concurrently and in contemplation of each other. 
• The rights, obligations or instruments can be separated, including consideration of any transferability provisions or restrictions in the legal documents constituting the transaction. 
• The exercise of one instrument results in the termination of the other instrument (e.g., through redemption, simultaneous exercise, or expiration). 

Is the financial instrument a liability under ASC 480?

Once the financial instruments have been identified, further consideration must be given to determine whether the Company is required to account for the financial instrument under ASC 480, which requires the entire instrument to be accounted for as a liability measured at fair value. 

In determining whether an embedded derivative must be bifurcated from the host instrument and accounted separately as a derivative instrument, the hybrid instrument must not already be recognized at fair value on the balance sheet with changes in fair value being reported in earnings. If the hybrid instrument is already recognized at fair value, there is no need to bifurcate the embedded derivative from the host. Therefore, an analysis must be performed to determine whether the instrument should be accounted for under ASC 480.

ASC 480 requires that financial instruments that are mandatorily redeemable on a specified or determinable date or upon an event certain to occur (e.g., the death of the holder) be classified as liabilities. If a financial instrument embodies an unconditional obligation to settle by issuing a variable number of equity shares, it shall also be classified as a liability. 

If it is redeemable, but not mandatorily redeemable, and the conversion alternatives do not result in a variable number of shares, then it would not be required to be classified as a liability under ASC 480. 

Identify the host contract

If the instrument is not accounted for at fair value under ASC 480, then the Company needs to further analyze the components of the hybrid instrument. A hybrid instrument consists of a host contract and embedded features which can affect the cash flows. 

First, the classification of the host instrument needs to be determined. An embedded feature does not require bifurcation if the feature is clearly and closely related to the host contract. Therefore, the nature of the host contract must be determined to assess whether any embedded features are considered clearly and closely related. 

Typically, legal form debt will be considered a debt host, whereas an equity-linked instrument may represent either an equity host or a debt host. To determine whether the host is debt or equity, all terms and features should be considered, and each feature weighed based on relevant facts and circumstances. 

The following summarizes which features are debt-like vs. equity-like:

Debt-like indicators	Equity-like indicators
Redemption provision	Conversion option
Cumulative/mandatory fixed dividends	Voting rights
Required collateral	Discretionary dividends based on earnings
Preference in liquidation	Participation in residual equity of issuer

Do the embedded derivatives need to be bifurcated and accounted for separately?

If the instrument is not already being measured at fair value (i.e., under ASC 480 or fair value option), an embedded derivative is required to be separated from the host contract and accounted for separately as a derivative instrument in accordance with ASC 815-10 if both of the following criteria are met: 

• The economic risks and characteristics of the embedded derivative are not clearly and closely related to those of the host contract..
• A separate instrument with the same terms as the embedded derivative would be a derivative instrument subject to the requirements of ASC 815-10. 

1. Determine whether the features are clearly and closely related to the host instrument

ASC 815-15-25-42 provides a four-step decision sequence to determine whether the features are clearly and closely related to the debt host instrument:

Step 1	Is amount paid upon settlement adjusted based on changes in an index? If yes, continue to Step 2. If no, continue to Step 3.
Step 2	Is the amount paid upon settlement indexed to an underlying other than interest rates or credit risk? If yes, no further analysis.
Step 3	Does the debt involve a substantial premium or discount? (Substantial is considered approximately 10% or more of the principal amount of the note.) If yes, proceed to Step 4.
Step 4	Does a contingently exercisable call or put accelerate the repayment of the contractual principal amount?

If clearly and closely related, the embedded feature does not need to be accounted for separately. If not clearly and closely related, the company must determine if it meets the definition of a derivative below.

1. Does the feature meet the definition of a derivative?

A derivative is an instrument that has all the following characteristics:

• One or more underlying– The underlying is a variable whose movements cause the fair value or cash flows of a derivative to fluctuate. 
• One or more notional amounts– The notional amount is the quantity that determines the size of the change caused by the movement of the underlying.
• No initial net investment– Derivatives typically don’t require any initial investment. Some derivatives require an initial net investment as compensation for time value (e.g., option premiums) or for “off-market” terms (e.g., a premium on an interest rate swap that pays the holder a higher fixed rate than current market rates would indicate). To possess the characteristics of a small initial investment, the initial investment must be smaller than what would be expected in an instrument that has a similar response to changes in market rates.
• Net settlement– The contract must either explicitly permit net settlement or put the receiving party in a position that is essentially equivalent to net settlement. Net settlement is a one-way transfer of an asset, usually cash, from the counterparty in a loss position to the counterparty in a gain position, settling the obligation. If it can be physically settled by delivery of shares, but those shares are not redeemable at the conversion date or publicly traded, they are not readily convertible to cash. Therefore, the delivery of these shares would not meet the settlement criteria.

If it meets the definition of derivative, then the embedded derivative must be bifurcated and accounted for separately. 

How should the embedded derivative be accounted for at inception and subsequently?

Once the embedded derivatives have been identified, further consideration is given as to whether the embedded derivatives should be evaluated individually or in the aggregate. If there are multiple embedded derivative features that would individually warrant separate accounting as a derivative instrument, they should be bundled together as a single compound embedded derivative that is bifurcated and separately accounted for. The value of the compound derivative is based on one unit of account rather than separate fair value measurements for each embedded derivative component that are added together. 

Embedded derivatives that are required to be bifurcated and accounted for separately are treated in the same manner as freestanding derivatives under ASC 815. The embedded derivative is recorded at fair value. Income and market approaches are used to measure the fair value of derivative instruments, which involves management judgment.

The combined embedded derivatives are subject to remeasurement each reporting period and the related changes in fair value are recorded as other income (expense) in the statement of operations.