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ASC 815-15-25-1 provides guidance on when an embedded component should be separated from its host instrument and accounted for separately as a derivative.

ASC 815-15-25-1

An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:

  1. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
  2. The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
  3. A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

Figure DH 4-3 illustrates the application of this guidance.
Figure DH 4-3
Decision tree for determining whether or not to separate an embedded derivative from a hybrid instrument
The following sections provide guidance on each of these criteria. For information on interest-only and principal-only strips see DH 3.2.12.

4.3.1 Clearly and closely related to the host contract

An embedded derivative is clearly and closely related to its host contract when its underlying economic characteristics and risks (i.e., the factors that cause a derivative to fluctuate in value) are clearly and closely related to the economic characteristics and risks of the host contract. That is, the clearly and closely related criterion simply asks whether the attributes of a derivative behave in a manner similar to the attributes of its host contract. For example, if an embedded component in a debt instrument pays a rate of return tied to the S&P 500 Index, the economic characteristics of the embedded derivative (e.g., equity-price risk) and the economic characteristics of the host contract (e.g., interest rate risk and issuer credit risk) are not clearly and closely related.
The application of the phrase “clearly and closely related” in the context of an embedded derivative analysis is different than it is in the context of the normal purchases and normal sales scope exception. See Question DH 3-1.
Question DH 4-4
When evaluating whether an equity-linked feature is considered clearly and closely related to an equity host, should a reporting entity consider whether the feature is considered indexed to the entity’s own stock, as discussed in ASC 815-40-15-5 through 15-8?
PwC response
Yes. Although the guidance for determining whether an instrument is considered indexed to a reporting entity’s own stock in ASC 815-40-15-5 through ASC 815-40-15-8 is not required to be used in the assessment of clearly and closely related under ASC 815-15-25-1(a), it may provide additional evidence for making the determination. We believe that when an embedded feature is considered indexed to stock price, it may be considered clearly and closely related to the equity host contract for the issuer.

4.3.2 Instrument is not measured at fair value

It is not necessary to separate a hybrid instrument measured at fair value through earnings into individual components that are both measured at fair value with changes in fair value reported in earnings. This provision simplifies the impact of ASC 815 for reporting entities in certain specialized industries (e.g., investment companies, pension plans, broker dealers). Since many of the instruments in those industries are measured at fair value in their entirety, no further accounting is required for embedded derivatives. This provision also applies to:
  • Investment securities that are classified as trading under ASC 320-10
  • Instruments for which the fair value option has been applied pursuant to ASC 815-15 or ASC 825-10

4.3.2.1 Fair value option for hybrid instruments

The fair value option (FVO) for financial instruments under ASC 825-10 can generally be applied to hybrid instruments, subject to certain limitations. In addition, ASC 815 provides an instrument-by-instrument fair value election for hybrid financial instruments that would require an embedded derivative to be bifurcated. Under either election, the hybrid financial instrument is carried at fair value with the change in fair value recognized currently in earnings, except for the effect of changes in own credit, which are recognized in other comprehensive income. See FV 5 for information on the FVO.

ASC 815-15-25-4

An entity that initially recognizes a hybrid financial instrument that under paragraph 815-15-25-1 would be required to be separated into a host contract and a derivative instrument may irrevocably elect to initially and subsequently measure that hybrid financial instrument in its entirety at fair value (with changes in fair value recognized in earnings). A financial instrument shall be evaluated to determine that it has an embedded derivative requiring bifurcation before the instrument can become a candidate for the fair value election.

ASC 815-15-25-5

The fair value election shall be supported by concurrent documentation or a preexisting documented policy for automatic election. That recognized hybrid financial instrument could be an asset or a liability and it could be acquired or issued by the entity. The fair value election is also available when a previously recognized financial instrument is subject to a remeasurement event (new basis event) and the separate recognition of an embedded derivative. The fair value election may be made instrument by instrument. For purposes of this paragraph, a remeasurement event (new basis event) is an event identified in generally accepted accounting principles, other than the recording of a credit loss under Topic 326, or measurement of an impairment loss through earnings under Topic 321 on equity investments, that requires a financial instrument to be remeasured to its fair value at the time of the event but does not require that instrument to be reported at fair value on a continuous basis with the change in fair value recognized in earnings. Examples of remeasurement events are business combinations and significant modifications of debt as defined in Subtopic 470-50.

The fair value election within ASC 815 is applicable only to a hybrid financial instrument in which both the host contract and embedded derivative are financial instruments. Examples of financial instruments include loans, securities, debt, foreign currency arrangements, and commodity contracts that require cash settlement. Examples of instruments that do not meet the definition include certain commodity contracts that allow settlement by delivery of the physical commodity, un-guaranteed lease residual interests, lease residual values that were guaranteed after inception, treasury stock, sales tax receivables, servicing rights, and unresolved legal settlements. See FV 5.5 for the election and application of the FVO within ASC 825.
Certain hybrid financial instruments that contain an embedded derivative required to be separated from the host contract can be accounted for by using one of the following methods..
  • Separate the embedded derivative and account for it as a derivative under the guidance in ASC 815 (i.e., measure it at fair value with changes in fair value recognized currently in earnings) and account for the host contract based on GAAP applicable to similar instruments that do not contain embedded derivatives (e.g., ASC 320-10, Investments—Debt Securities).
  • Irrevocably elect to apply the FVO and measure the entire hybrid financial instrument (including the embedded derivative) at fair value with changes in fair value recognized currently in earnings, except for the effect of changes in own credit, which are recognized in other comprehensive income. This fair value election can be made only when the hybrid financial instrument is acquired or issued or when it is subject to a remeasurement (i.e., new basis) event.

Question DH 4-5
Are all hybrid financial instruments that meet the definition of a financial instrument in their entirety (i.e., both the host contract and the embedded derivative are financial instruments) afforded the fair value option under ASC 815-15-25-4?
PwC response
No. ASC 815-15-25-6 scopes out those hybrid financial instruments described in ASC 825-10-50-8.

Excerpt from ASC 825-10-50-8

  1. Employers' and plans' obligations for pension benefits, other postretirement benefits including health care and life insurance benefits, postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements (see Topics 710, 712, 715, 718, and 960)
  2. Substantively extinguished debt subject to the disclosure requirements of Subtopic 405-20
  3. Insurance contracts, other than financial guarantees (including financial guarantee insurance contracts within the scope of Topic 944) and investment contracts, as discussed in Subtopic 944-20
  4. Lease contracts as defined in Topic 842 (a contingent obligation arising out of a cancelled lease and a guarantee of a third-party lease obligation are not lease contracts and are subject to the disclosure requirements in this Subsection)
  5. Warranty obligations (see Topic 450 and the Product Warranties Subsections of Topic 460)
  6. Unconditional purchase obligations as defined in paragraph 440-10-50-2
  7. Investments accounted for under the equity method in accordance with the requirements of Topic 323
  8. Noncontrolling interests and equity investments in consolidated subsidiaries (see Topic 810)
  9. Equity instruments issued by the entity and classified in stockholders' equity in the statement of financial position (see Topic 505)
  10. Receive-variable, pay-fixed interest rate swaps for which the simplified hedge accounting approach is applied (see Topic 815)
  11. Fully benefit-responsive investment contracts held by an employee benefit plan.
  12. Investments in equity securities accounted for under the measurement guidance for equity securities without readily determinable fair values (see Topic 321)
  13. Trade receivables and payables due in one year or less
  14. Deposit liabilities with no defined or contractual maturities.
  15. Liabilities resulting from the sale of prepaid stored-value products within the scope of paragraph 405-20-40-3.

4.3.3 Embedded component would be accounted for as a derivative

An embedded derivative meets the criterion in ASC 815-15-25-1(c) if it would meet the definition of a derivative in ASC 815-10-15-83 and would not be subject to any of the scope exceptions in ASC 815-10-15-13 or ASC 815-15-15-3 if it were a freestanding instrument. See DH 2 for information on the definition of a derivative and DH 3 for information on the related scope exceptions.
While the analysis under ASC 815-15-25-1(c) is generally performed as if the embedded derivative is a freestanding instrument, there is one important exception to this approach. ASC 815-15-25-14 clarifies that the guidance in ASC 480-10-25-4 through ASC 480-10-25-14 for distinguishing liabilities from equity should not be considered in determining whether an embedded derivative would be classified in equity for purposes of applying the scope exception in ASC 815-10-15-74(a). This is because ASC 480, Distinguishing Liabilities from Equity, only applies to freestanding instruments. ASC 480 requires certain instrument indexed to an issuer’s own stock to be accounted for as liabilities. See FG 5.5 for information on the scope and application of ASC 480.

4.3.4 Application exception for foreign exchange contracts

As described in ASC 815-15-15-10, some foreign currency derivatives embedded in nonfinancial contracts do not have to be separated from their hosts.

ASC 815-15-15-10

An embedded foreign currency derivative shall not be separated from the host contract and considered a derivative instrument under 815-15-25-1 if all of the following criteria are met:

  1. The host contract is not a financial instrument.
  2. The host contract requires payment(s) denominated in any of the following currencies:
    1. The functional currency of any substantial party to that contract
    2. The currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions)
    3. The local currency of any substantial party to the contract
    4. The currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment which the party operates is highly inflationary (as discussed in paragraph 830-10-45-11).
  3. Other aspects of the embedded foreign currency derivative are clearly and closely related to the host contract.
The evaluation of whether a contract qualifies for the exception in this paragraph should be performed only at inception of the contract.

ASC 815-15-15-11 clarifies that the determination of a counterparty’s functional currency should be made “based on available information and reasonable assumptions about the counterparty; representations from the counterparty are not required.” See ASC 815-15-55-213 through ASC 815-15-55-215 for a case study illustrating this determination.
ASC 830-10-55-5 provides guidance on economic factors that should be considered when determining the functional currency of a reporting entity. These include indicators relating to cash flows, sales prices, sales market, expenses, financing, and intra-entity transactions and arrangements. A reporting entity should not necessarily rely on a single indicator, such as the currency in which the counterparty’s sales prices are denominated; all relevant available information should be considered when determining the functional currency of a counterparty.
Question DH 4-6
Is a guarantor considered a “substantial party to a contract” under ASC 815-15-15-10?
PwC response
No. The implementation guidance in ASC 815-15-55-84 through ASC 815-15-55-86 clarifies that a guarantor is not a substantial party to a contract even if the guarantor is a related party (e.g., parent company). The evaluation of embedded derivatives should be conducted by the legal entity that is party to the contract.
Question DH 4-7
Does the fact that an index is quoted in a particular currency mean that it is routinely denominated in that currency? For example, if a coal index is quoted in US dollars, does that mean that coal is traded primarily in US dollars?
PwC response
No. This analysis will involve more than reviewing in what currency the product or service is typically quoted. Example 2 in ASC 815-15-55-96 clarifies that the phrase “routinely denominated in international commerce” should be based on how similar transactions for certain products or services are structured around the world, not in just one local area. If similar transactions for a certain product or service are routinely denominated in international commerce in different currencies, the exception in ASC 815-15-15-10 does not apply.
Question DH 4-8
A reporting entity concludes that changes in its operations will result in a change to its functional currency. Should the reporting entity reassess its existing contracts to determine if embedded derivative features should be separated?
PwC response
No. ASC 815-15-15-10 states that the qualification for the scope exception should be performed only at the inception of the contract. Although the change in functional currency is significant, we do not believe it would require a reassessment of the contracts under ASC 815-15-15-10.

Example DH 4-1, Example DH 4-2, and Example DH 4-3 illustrate the analysis for determining whether a contract contains an embedded foreign currency derivative.
EXAMPLE DH 4-1
Contract with payments linked to foreign-exchange rates
USA Corp is a US registrant that has a US dollar (USD) functional currency.
On August 1, 20X1, USA Corp enters into a contract for professional services denominated in USD. The terms of the contract require quarterly payments in USD. The contract also requires a fixed adjustment to the quarterly payment amount when the USD / Japanese yen (JPY) exchange rate reaches a specified level.
Is there an embedded foreign currency derivative that must be separated from the host contract?
Analysis
The contract payment adjustment is an embedded foreign currency derivative that should be separated from the professional services contract. Because the quarterly contract payments are not denominated in JPY (nor is it in substance JPY denominated), but are instead simply indexed to JPY, the embedded derivative does not qualify for the scope exception in ASC 815-15-15-10.
EXAMPLE DH 4-2
Foreign currency denominated lease guaranteed by parent
USA Corp is a US registrant that has a USD functional currency. Deutsche AG is a consolidated subsidiary of USA Corp located in Germany, which has the euro as its functional currency.
Deutsche AG enters into a lease with Canadian Corp (which has a Canadian dollar functional currency), which requires annual lease payments in USD. USA Corp guarantees Deutsche AG’s payments on the lease.
Is there an embedded foreign currency derivative that must be separated from the host contract?
Analysis
The lease contains an embedded derivative that converts euro lease payments to USD that should be separated by Deutsche AG and in the consolidated financial statements of USA Corp. The substantial parties to the lease are Deutsche AG and Canadian Corp. Even though USA Corp guarantees the lease, it is not a substantial party to the contract. Since the lease payments are not denominated in one of the functional or local currencies of the substantial parties to the lease or a currency in which leases are routinely denominated in international commerce, the embedded derivative does not qualify for the scope exception in ASC 815-15-15-10.
EXAMPLE DH 4-3
Commodity contract
USA Corp is a US registrant that has a USD functional currency.
USA Corp enters into a contract to purchase a commodity from Britannia PLC, which has a British pound sterling functional currency. The commodity purchase contract is denominated in euros.
The commodity underlying the contract is readily convertible to cash and USA Corp does not meet the requirements for applying the normal purchases and normal sales scope exception.
Is there an embedded foreign currency derivative that must be separated from the host contract?
Analysis
Since the commodity contract meets the definition of a derivative (because the underlying commodity is readily convertible to cash) and is not eligible for a scope exception, it should be accounted for as a derivative in its entirety. Therefore, there is no embedded foreign currency derivative to be separated; embedded derivatives are not separated from contracts that are accounted for as derivatives in their entirety.
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