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The most common type of hosts are debt hosts. See DH 4.5.1 for information regarding how to determine whether an equity contract is a debt or equity host.
Generally, embedded derivatives in debt host contracts are not clearly and closely related if they introduce risks that are not typical for debt instruments or if the return that investors may receive is significantly leveraged (i.e., favorably or unfavorably impacted to a significant degree by the embedded derivative). When applying the clearly and closely related criterion in ASC 815-15-25-1(a) to a debt host, the focus should be on determining whether the economic characteristics and risks of the embedded derivative have features unrelated to interest rates (e.g., equity-like or commodity-like features). Alternatively, when the characteristics of the derivative are related to interest rates, the focus should be on determining whether the features involve leverage or change in the opposite direction as interest rates (e.g., an inverse floater).

4.4.1 Common embedded features

Generally, an embedded derivative is clearly and closely related to a debt host if it is one of the following.
  • A non-leveraged interest rate or index
  • A non-leveraged index of inflation
  • The creditworthiness of the debtor
  • An issuer-exercisable call or a holder-exercisable put that does not contain an embedded interest rate derivative under the guidance in ASC 815-15-25-26 and meets the requirements for not separating put and call options in ASC 815-15-25-41 through ASC 815-15-25-42
ASC 815-15-25-23 through ASC 815-15-25-51 provides guidance on how to apply the clearly and closely related criterion to different hybrid debt instruments with various embedded features.
See Question DH 4-9 for a question on a debt instrument containing an embedded derivative.
Question DH 4-9
If a debt instrument contains an embedded derivative that results in the interest payments being indexed to the price of silver (or some other metal or commodity index) and they are settled in cash or in a financial instrument or commodity that is readily convertible to cash, must the derivative be separated from the host contract?
PwC response
Yes. In this situation, the issuer would be viewed as having (1) issued debt at a certain interest rate, and (2) entered into a swap contract to convert the index that determines the rate of interest from an interest rate index to a commodity index. The swap contract would not be considered clearly and closely related to the host contract because its economic characteristics are linked to a commodity index (rather than an interest rate index). Therefore, assuming the hybrid instrument is not being carried at fair value with changes recognized in current earnings and a separate instrument with the same terms as the embedded feature would be a derivative instrument under ASC 815, the embedded derivative should be separated from the host contract and accounted for separately as a derivative.

4.4.2 Debt host contracts with embedded interest rate derivatives

When an embedded interest component alters the contractual interest on its host contract, it may not be considered clearly and closely related even though they both have interest rate underlyings. For example, a debt instrument that provides a return that is positively leveraged (i.e., favorably impacted by the embedded derivative) to a significant degree may contain an embedded interest rate derivative that should be accounted for separately.
ASC 815-15-25-26 provides guidance on evaluating whether an embedded interest rate derivative is considered clearly and closely related to a debt host contract. This guidance should be applied if the only underlying of the embedded component is interest rates.

ASC 815-15-25-26

For purposes of applying the provisions of paragraph 815-15-25-1, an embedded derivative in which the only underlying is an interest rate or interest rate index (such as an interest rate cap or an interest rate collar) that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract that is considered a debt instrument is considered to be clearly and closely related to the host contract unless either of the following conditions exists:

  1. The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment (that is, the embedded derivative contains a provision that permits any possibility whatsoever that the investor’s [the holder's or the creditor's] undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms).
  2. The embedded derivative meets both of the following conditions:
    1. There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor’s initial rate of return on the host contract (that is, the embedded derivative contains a provision that could under any possibility whatsoever at least double the investor’s initial rate of return on the host contract).
    2. For any of the possible interest rate scenarios under which the investor’s initial rate of return on the host contract would be doubled (as discussed in (b)(1)), the embedded derivative would at the same time 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 that involves a debtor with a credit quality similar to the issuer’s credit quality at inception.

Although it could be argued that the decision to exercise a put or call option embedded in a debt instrument is based on interest rates and credit, “plain vanilla” and “non-contingent” calls and puts are considered to be solely indexed to interest rates, as contemplated in ASC 815-15-25-26.
ASC 815-15-25-29 clarifies that in the case of a put option that permits, but does not require, the lender to settle the debt instrument in a manner that causes it not to recover substantially all of its initial recorded investment, the guidance in paragraph (a) of ASC 815-15-25-26 does not apply. As illustrated in Example 10 in ASC 815-15-55-128, provisions that allow the investor to choose to accept a settlement that is substantially less than its initial investment do not conflict with ASC 815-15-25-26(a).
ASC 815-15-25-37 and ASC 815-15-25-38 clarify that in the case of a call option that permits, but does not require, the reporting entity to accelerate the repayment of the debt, the guidance in paragraph (b) above is not applicable.

4.4.2.1 Recovering substantially all of the investment

We believe “substantially all” means at least 90% of the investment. Therefore, if the embedded component in a debt instrument could result in the lender receiving less than 90% of its initial recorded investment, it likely creates an embedded interest rate derivative that should be accounted for separately. This analysis should be performed on an undiscounted basis and consider all possible events without regard to probability.

4.4.2.2 Doubling the initial and market rate of return

This test is commonly referred to as the double-double test. We believe the initial rate of return that should be used in the double-double test is that of the host debt instrument without the embedded derivative, not the combined hybrid instrument (debt instrument with the embedded derivative). The initial rate of return on the host debt instrument may differ from the stated initial rate of return on the hybrid instrument as the yield on the hybrid may be affected by the embedded derivative. The analysis should be performed without regard to the probability of the event occurring.
When considering transactions with multiple elements, such as debt issued with warrants, the double-double test should be performed after proceeds have been allocated to the individual transactions. However, the terms of the combined transaction should be considered when performing the test. For example, if upon the exercise of a put option embedded in a debt instrument issued with warrants, the lender will receive par value for the combination of the debt and warrants, it is less likely to meet the double-double test than if the lender would receive par value for the debt and the warrants remain outstanding.
For convertible debt within the scope of the cash conversion guidance in ASC 470-20, the double-double test should be performed before the bond is bifurcated, as described in FG 6.6.1. Therefore, when evaluating whether an embedded derivative should be accounted for separately, the discount created by separating the conversion option should not be considered.
See FG 1.6.1.3 for examples illustrating the application of the guidance in ASC 815-15-25-26.
See Question DH 4-10 for a question on a variable rate debt instrument containing an interest rate floor or cap.
Question DH 4-10
If a variable-rate debt instrument contains an interest rate floor or cap, such that the interest rate could never fall below or exceed a specified level, would the issuer be required to separate the interest rate floor or cap from the debt instrument?
PwC response
Probably not. ASC 815-15-25-32 clarifies that interest rate caps and floors are typically considered clearly and closely related to a debt host contract. However, the analysis in ASC 815-15-25-26 should be performed. If the provisions of either ASC 815-15-25-26(a) or (b) are met, then the interest rate floor or cap must be separated from the debt instrument. In applying this guidance, caps are typically considered clearly and closely related to a debt host contract; floors are generally considered clearly and closely related to a debt host contract unless they are issued deeply in the money.

Question DH 4-11 discusses whether the economic characteristics and risks of a leveraged inflation feature is considered clearly and closely related to the economic characteristics and risks of the host contract.
Question DH 4-11
A reporting entity issues 10-year inflation-linked bonds that pay interest semiannually. The interest on the bonds is set at a fixed rate. The principal amount on the bonds is indexed to a leverage-adjusted Consumer Price Index (CPI) (the “leverage inflation feature”). That is, at the end of each semi-annual period, the principal amount on the securities will adjust based on 1.5 times the published CPI for a specific period. The interest payment is calculated by multiplying the adjusted principal by the annualized interest rate. When the securities mature, the issuer pays the greater of the original or adjusted principal.

The leveraged inflation feature is an embedded derivative because its explicit terms affect some of the cash flows required by the contract in a manner similar to a derivative.

Are the economic characteristics and risks of the leveraged inflation feature considered clearly and closely related to the economic characteristics and risks of the host contract as described in ASC 815-15-25-1(a)? For purposes of applying the clearly and closely related criterion, may the criteria in ASC 815-15-25-26 be considered in the analysis?
PwC response
No. The economic characteristics and risks of the leveraged inflation feature are not considered clearly and closely related to the economic characteristics and risks of the host contract. ASC 815-15-25-50 provides guidance on inflation-indexed contracts.

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.

This guidance applies to hybrid instruments that have either their principal amounts or periodic interest payments referenced to an inflation index; however, the conclusion that an inflation provision is considered clearly and closely related to a host debt instrument only applies to nonleveraged inflation provisions. Since an inflation rate is not an interest rate, we do not believe a reporting entity may consider the criteria in ASC 815-15-25-26 as support for not separating a leveraged inflation feature from its host debt instrument. Question DH 4-12, Question DH 4-13 and Question DH 4-14 ask whether a loan contains an embedded derivative that should be separated from the host debt instrument.
Question DH 4-12
A reporting entity obtains a five-year loan that pays interest equal to the rolling average of one-month LIBOR over the prior 12 months and resets every month. At inception of the loan, the interest rate for one-month LIBOR is 2% and the twelve-month rolling average of one-month LIBOR interest rates is also 2%.

Does the loan contain an embedded derivative that should be separated from the host debt instrument?
PwC response
Probably. A full analysis of ASC 815-15-25-26(b) would need to be performed to determine if the embedded derivative should be separated.
This debt instrument is indexed to the LIBOR curve and has a variable interest rate that resets monthly. The host contract can be viewed as a five-year loan with a rate of one-month LIBOR that resets every month. Because the interest rate on the loan is an average of twelve one-month LIBOR rates, the interest rate on the loan will lag the movement in one-month LIBOR. Over the term of the loan, it is possible that one-month LIBOR interest rates could rise to 6% and eventually the rate on the loan would reach 6% (e.g., if rates remained at 6% for a period of twelve months). If suddenly one-month LIBOR interest rates over a two-month period then dropped to 2%, the rate on the loan would be approximately 5.3%, which would be twice the initial rate of return of the host contract of 2% while at the same time twice the then current one-month LIBOR market rate of 2%. Based on an analysis of ASC 815-15-25-26(b), this twelve-month moving average feature would not be clearly and closely related to the debt host. Assuming the other criteria in ASC 815-15-25-1 are met, the embedded derivative (i.e., an interest rate swap) would have to be accounted for separately under ASC 815.
Question DH 4-13
A reporting entity obtains a five-year loan with an interest rate that resets every three months based on the five-year Constant Maturity Swap (CMS) index, less a constant spread. Does the loan contain an embedded derivative that should be separated from the host debt instrument?
PwC response
Probably. A full analysis of ASC 815-15-25-26(b) would need to be performed to determine if the embedded derivative should be separated.
In this loan, the CMS index is essentially the indicated rate in effect at any point in time for the five-year point on the LIBOR swap curve. Because the debt instrument is indexed based on the LIBOR curve and has a variable interest rate that resets quarterly, the host contract may be considered to be a five-year loan with an interest rate based on three-month LIBOR that resets every three months. If the yield curve steepens sharply whereby the short-end of the LIBOR curve drops to 1% while the mid to long-end of the LIBOR curve increases to 10% or more, there could be a scenario in which the interest rate on the loan would be double the investor’s initial rate of return and at the same time be twice the then market rate of return of the host contract. Based on an analysis of ASC 815-15-25-26(b), it would appear that the CMS index feature would not be clearly and closely related to the debt host. Assuming the other criteria in ASC 815-15-25-1 are met, the embedded derivative (i.e., the interest rate swap) would have to be accounted for separately under ASC 815.
Question DH 4-14
A reporting entity enters into a five-year note that has an interest rate based on the ten-year Constant Maturity Treasury (CMT) index, which resets every 90 days. Does the note contain an embedded derivative that should be separated from the host debt instrument?
PwC response
Probably. A full analysis of ASC 815-15-25-26(b) would need to be performed to determine if the embedded derivative should be separated.
The host contract in this note is a five-year debt instrument with a rate that resets every 90 days. Because the yield curve that the ten-year CMT index is based on may be flatter or steeper than the 90-day CMT index, there is a possibility that the investor will double their initial rate of return and the embedded derivative could also result in a return that is twice the then-current market return.
Some have argued that the embedded derivative in this type of structure does not meet the ASC 815-15-25-26(b) criterion by analogy to Case C in ASC 815-15-55-176 through ASC 815-15-55-178. Case C has a very similar instrument (i.e., a de-levered floater) but clearly indicates that “there appears to be no possibility of the embedded derivative increasing the investor’s rate of return on the host contract to an amount that is at least double the initial rate of return on the host contract [see ASC 815-15-25-26(b)].” The conclusion in Case C was based on the specific facts in Case C (i.e., it was assumed that it was not possible for the investor to double its initial rate of return). However, when there is a possibility of the investor doubling its initial rate of return while at the same time doubling the then-current rate of return, a CMT index feature would not be clearly and closely related to the debt host; assuming the other criteria in ASC 815-15-25-1 are met, the embedded derivative (i.e., the interest rate swap) would have to be accounted for separately under ASC 815.

4.4.3 Embedded put or call options

Put features allow the debt holder to demand repayment, and call features allow the issuer to repurchase the debt. It should be noted that in the context of debt instruments, puttable debt (i.e., that the holder may require to be repaid early) is often referred to in practice as callable, although callable debt theoretically is prepayable only at the issuer’s option. Generally, a put or call option is considered clearly and closely related to its debt host unless it is leveraged (i.e., it creates more interest rate and/or credit risk than is inherent in the host instrument). For example, debt issued at par value that is puttable at two times the par value upon the occurrence of a specified event may have an embedded component that is not clearly and closely related to its debt host instrument.
Figure DH 4-4 illustrates the analysis to determine whether a put or call option is clearly and closely related to its debt host instrument. If the put or call option is not considered clearly and closely related to its host debt instrument based on this analysis, it should be separately accounted for as a derivative under the guidance in ASC 815.
Figure DH 4-4
Determining whether an embedded put or call option is clearly and closely related to its host debt instrument
See FG 1.6 for further guidance on put and call options embedded in debt instruments, including illustrative examples. Example DH 4-4 illustrates the different analyses for a put option and a term extension option.
EXAMPLE DH 4-4
Analysis of put options and options to extend debt
Investor Corp purchases two bonds: Bond A and Bond B. Both bonds are issued by the same issuer at par and have a coupon rate of 6%.
Bond A has a stated maturity of ten years, but the investor can put it back to the issuer at par after three years.
Bond B has a stated maturity of three years, but after three years the investor can extend the maturity to ten years (i.e., seven more years) at the same initial interest rate (i.e., neither the interest rate nor the credit spread are reset to the then-current market interest rate).
Assume the following scenarios exist at the end of three years:
Scenario 1: The issuer’s interest rate for seven-year debt is at 8%. The investor will put Bond A back to the issuer and reinvest the par amount of the bond at 8%. The investor will not extend the maturity of Bond B and instead will reinvest the principal at 8%.
Scenario 2: The issuer’s interest rate for seven-year debt is at 4%. The investor will not put Bond A back to the issuer and instead will continue to receive 6% for the next seven years. The investor will extend the term of Bond B and continue to receive 6% for the next seven years.
How should the embedded derivatives in Bond A and Bond B be analyzed?
Analysis
Although in both scenarios the issuer and Investor Corp are in the same economic position with respect to Bond A and Bond B, ASC 815 may require that they be treated differently.
An analysis of ASC 815-15-25-37 through ASC 815-15-25-41 would indicate that the put option in Bond A should not be separated because calls and puts in debt hosts are generally clearly and closely related to the host contract, unless they meet the conditions in ASC 815-15-25-42 or ASC 815-15-25-26.
On the other hand, ASC 815-15-25-44 would indicate that the term-extending option in Bond B may not be clearly and closely related to its debt host because its interest rate and credit spread are not reset to the then-current market interest rate when the option is exercised. However, only term-extending options in debt hosts that cause an investor to potentially not recover substantially all of its recorded investment (i.e., lose principal) would be considered not clearly and closely related. Since the term extension option is within the control of the investors, they could not be forced into a term extension in which (on a present value basis) they would not be recovering substantially all of their initial net investment so the term-extending option embedded in Bond B is clearly and closely related.

For host contracts other than debt hosts, ASC 815-15-25-45 requires an analysis to determine whether term extension options should be separated. Notwithstanding the guidance in ASC 815-15-25-44 and ASC 815-15-25-45, many term-extending options will not meet the definition of derivatives because they cannot be net settled. Additionally, from the perspective of the issuer of the loan agreement, a term-extending option when only the issuer/borrower has the right to extend the agreement would be considered a loan commitment and meet the scope exception for loan commitments, as described in ASC 815-10-15-69 through ASC 815-10-15-71. Therefore, many term-extending options will not have to be separated from the host debt instrument, even though they may not be clearly and closely related to their host contracts because a freestanding instrument with the same terms would not meet the definition of a derivative or would be eligible for a scope exception.

4.4.3.1 Put or call option accelerates repayment of principal on debt

The reporting entity should first determine whether exercise of the put or call option accelerates the repayment of principal on the debt. ASC 815-15-25-41 provides guidance on put and call options that do not accelerate the repayment of the debt.

ASC 815-15-25-41

Call (put) options that do not accelerate the repayment of principal on a debt instrument but instead require a cash settlement that is equal to the price of the option at the date of exercise would not be considered to be clearly and closely related to the debt instrument in which it is embedded.

If exercise of a put or call option accelerates the repayment of the debt, further analysis is required to determine whether the put or call option is clearly and closely related to its debt host.

4.4.3.2 Nature of the settlement paid upon exercise of a put or call

The reporting entity should determine if the amount paid upon exercise of a put or call option is based on changes in an index rather than simply being the repayment of principal at par or at a fixed premium or discount. For example, a put option that entitles the holder to receive an amount determined by the change in the S&P 500 index (i.e., par value of the debt multiplied by the change in the S&P 500 Index over the period the debt is outstanding) is based on changes in an equity index. On the other hand, debt callable at a fixed price of 101% is not based on changes in an index. Debt callable at a price of 108% at the end of year 1, 106% at the end of year 2, and 104% at the end of year 3 is also not based on changes in an index because the premium changes simply due to the passage of time.
If the amount paid upon exercise of a put or call option is based on changes in an index, then the reporting entity should determine whether the index is an interest rate index or credit index (specifically, the issuer’s credit). If the index is not an interest rate or credit index, the put or call option is not clearly and closely related to the debt host instrument and should be separately accounted for as a derivative under the guidance in ASC 815.
If the amount paid upon exercise of the put or call option is (1) not based on changes in an index, or (2) based on changes in an interest rate or related to the issuer’s credit, further analysis is required to determine whether the put or call option is clearly and closely related. Question DH 4-15 discusses if an embedded put or call option, that allows the lender or reporting entity to receive the fair value of the debt upon exercise, is considered clearly and closely related to its host.
Question DH 4-15
Is an embedded put or call option that allows the lender or reporting entity to receive the fair value of the debt upon exercise considered clearly and closely related to its host?
PwC response
Maybe. There are circumstances when a fair value put or call option may not be considered clearly and closely related to its debt host. However, the option generally would not have a material value because its strike price is equal to the underlying’s fair value. The purpose of the option is to provide liquidity to the option holder.

4.4.3.3 Evaluating whether a substantial discount or premium exists

Practice generally considers a discount or premium equal to or greater than 10% of the par value of the host debt instrument to be substantial. Similarly, a spread between the debt’s issuance price and the price at which the put or call option can be exercised that is equal to or greater than 10% is also generally considered substantial. However, 10% is not a bright-line; all relevant facts and circumstances should be considered to determine whether the discount or premium is substantial. A put or call option that requires a debt instrument to be repaid at its accreted value is generally not considered to involve a substantial discount or premium.
If the put or call involves a substantial premium or discount, then it should be evaluated to determine whether it is contingently exercisable. If it does not involve a substantial premium or discount, it should be evaluated to determine whether it contains an embedded interest rate derivative that should be separated. See DH 4.4.2 for information on how to determine whether a debt host contract contains an embedded interest rate derivative.

4.4.3.4 Evaluating if a put or call option is contingently exercisable

The reporting entity should then determine whether the put or call option is contingently exercisable. A debt instrument that an issuer can call upon a commodity price level reaching a specified price, bonds puttable if interest rates reach a specified level, and bonds puttable upon a change in control are examples of instruments with put and call options that are contingently exercisable. A put or call is considered contingently exercisable whether or not the contingency has occurred.
If the put or call is contingently exercisable and meets the other requirements shown in Figure DH 4-4, the put or call is not clearly and closely related to its host debt instrument. If it is not contingently exercisable, then it should be evaluated to determine whether it contains an embedded interest rate derivative that should be separated. See DH 4.4.2 for information on how to determine whether a debt host contract contains an embedded interest rate derivative.

4.4.4 Issuer’s accounting for convertible debt

Convertible debt is a hybrid instrument composed of at least (1) a debt host instrument and (2) one or more conversion features (i.e., a written call option requiring delivery of company stock upon exercise of the conversion option by the holder). Many convertible debt instruments contain a conversion option with several settlement features that are interrelated. If, after performing the analysis of one settlement feature, it is determined that it should be separately accounted for as a derivative, then the entire conversion option should be separated and accounted for as a single derivative. The debt may also contain other embedded derivatives (e.g., puts and calls, contingent interest, make-whole provisions, other interest features). See DH 4.8.3 for information on multiple derivative features embedded in a single hybrid instrument.
When considering whether an embedded equity-linked component is clearly and closely related to its host instrument, a reporting entity should first determine whether the host is an equity host or a debt host. Instruments classified as debt, such as convertible debt instruments, are considered debt hosts. An embedded equity-linked component is generally not considered clearly and closely related to a debt host. See DH 4.5.1 for information on determining whether an equity instrument is a debt or equity host.
An issuer should next determine whether the embedded conversion option meets the definition of a derivative. When evaluating whether an equity-linked component meets the definition of a derivative, the net settlement provision in ASC 815-10-15-83(c) often receives the most attention; the provisions in ASC 815-10-15-83(a) and ASC 815-10-15-83(b) are generally met. To determine whether the net settlement criterion in ASC 815-10-15-83(c) is met, a reporting entity should first determine whether gross physical settlement is required. Gross physical settlement occurs when the asset to be delivered in settlement is both (1) related to the underlying and (2) delivered in quantities equal to the equity component’s notional amount. If gross physical settlement is required, a reporting entity should analyze whether the asset to be delivered at settlement (e.g., shares) is readily convertible to cash. The following considerations are typically relevant to that analysis.
  • Whether the shares received upon settlement are publicly-traded
  • Whether the number of shares to be exchanged is large relative to the daily transaction volume
  • The effect of any restrictions on the future sale of any shares received
A reporting entity should also consider the appropriate unit of account when determining whether the asset to be delivered at settlement is readily convertible to cash. In assessing whether a contract that can contractually be settled in increments meets the definition of net settlement, a reporting entity must determine whether or not the quantity of the asset to be received from the settlement of one increment is considered readily convertible to cash. If the contract can be settled in increments and those increments are considered readily convertible to cash, the entire contract meets the definition of net settlement.
If gross physical settlement is not required, an equity-linked component may nevertheless meet the net settlement provisions in ASC 815-10-15-83(c)(1) or ASC 815-10-15-83(c)(2). See DH 2 for further information on how to determine whether a contract meets the definition of a derivative.
If the conversion option meets the definition of a derivative, it would still be outside the scope of ASC 815 if it qualifies for the scope exception for certain contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a).

Excerpt from ASC 815-10-15-74

Notwithstanding the conditions of paragraphs 815-10-15-13 through 15-139, the reporting entity shall not consider the following contracts to be derivative instruments for purposes of this Subtopic:

  1. Contracts issued or held by that reporting entity that are both:
    1. Indexed to its own stock
    2. Classified in stockholders’ equity in its statement of financial position.

An embedded component is considered indexed to a reporting entity’s own stock if it meets the requirements specified in ASC 815-40-15. See FG 5.6.2 for information on these requirements.
An embedded component that involves a reporting entity’s own equity would be classified in shareholders’ equity if it meets the requirements for equity classification in ASC 815-40-25. See FG 5.6.3 for information on these requirements.
See FG 6.5.1 for information on the derecognition of convertible debt with a separated conversion option.

4.4.5 Conversion option no longer requires separate accounting

ASC 815-15-35-4 provides guidance that addresses a reporting entity’s accounting for a previously separated conversion option that no longer meets the criteria for separate accounting.

ASC 815-15-35-4

If an embedded conversion option in a convertible debt instrument no longer meets the bifurcation criteria in this Subtopic, an issuer shall account for the previously bifurcated conversion option by reclassifying the carrying amount of the liability for the conversion option (that is, its fair value on the date of reclassification) to shareholders’ equity. Any debt discount recognized when the conversion option was bifurcated from the convertible debt instrument shall continue to be amortized.

ASC 815-15-40-1 and ASC 815-15-40-4 address a reporting entity’s accounting upon conversion or extinguishment of an instrument which has previously been separated.

ASC 815-15-40-1

If a holder exercises a conversion option for which the carrying amount has previously been reclassified to shareholders’ equity pursuant to paragraph 815-15-35-4, the issuer shall recognize any unamortized discount remaining at the date of conversion immediately as interest expense.

ASC 815-15-40-4

If a convertible debt instrument with a conversion option for which the carrying amount has previously been reclassified to shareholders’ equity pursuant to the guidance in paragraph 815-15-35-4 is extinguished for cash (or other assets) before its stated maturity date, the entity shall do both of the following:

  1. The portion of the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment shall be allocated to equity.
  2. The remaining reacquisition price shall be allocated to the extinguishment of the debt to determine the amount of gain or loss.

4.4.6 Beneficial interests in securitizations

Many securitization transactions involve the transfer of financial assets to a limited-purpose entity through one or more steps. The securitization entity issues various interests in security form (hence the term “securitization”) to third parties that entitle the holders to the cash flows generated by the entity’s underlying financial assets. These interests are commonly referred to as “beneficial interests” in those assets. ASC 860, Transfers and Servicing, defines beneficial interests.

Definition from ASC 860-10-20

Beneficial Interests: Rights to receive all or portions of specified cash inflows received by a trust or other entity, including, but not limited to, all of the following:

  1. Senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through
  2. Premiums due to guarantors
  3. Commercial paper obligations
  4. Residual interests, whether in the form of debt or equity

Beneficial interests can take many different forms, ranging from debt securities to equity interests issued by a limited partnership or limited liability company. Examples of beneficial interests in securitizations include mortgage-backed securities, asset-backed securities, credit-linked notes, collateralized debt obligations, and interest-only (IO) or principal-only (PO) strips. The primary investors in beneficial interests in securitizations are insurance companies, banks, broker-dealers, hedge funds, pension funds, and other individuals or companies that maintain a significant investment or trading portfolio. Corporate treasury groups may also invest in beneficial interests. For example, many corporations invest in mortgage-backed securities issued by government-sponsored enterprises, such as Freddie Mac or Fannie Mae. The entity selling assets in a securitization transaction often retains interests in the assets sold. Commonly referred to as retained interests, these are also regarded as forms of beneficial interests.
Figure DH 4-5 provides an overview of the process of applying ASC 815 to beneficial interests in securitizations. See ASC 815-15-55-137 through ASC 815-15-55-156 for examples of how to apply the clearly and closely related criterion to beneficial interests.
Figure DH 4-5
Decision tree for application of ASC 815 to beneficial interests in securitizations
Figure 4-5 Decision tree for application of ASC 815 to beneficial interests in securitizations View image

4.4.6.1 Accounting for derivatives embedded in beneficial interests

Beneficial interests should be evaluated to determine whether they meet the definition of a derivative in ASC 815. See DH 2 for information on the definition of a derivative. If the beneficial interest is an IO or PO strip it may qualify for a scope exception; see DH 3.2.12 for information on the scope exception for certain IOs and POs.
Certain beneficial interests in securitizations (that are not derivatives within the scope of ASC 815) are accounted for like debt securities under ASC 320, as detailed in ASC 860-20-35-2. See LI 3.2.2.1 for information on these instruments. Question DH 4-16 discusses how a reporting entity should interpret the criterion for beneficial interests in determining whether an instrument meets the definition of a derivative.
Question DH 4-16
Part of the definition of a derivative requires a derivative to have “an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.” How should a reporting entity interpret the criterion for beneficial interests?
PwC response
To determine whether this criterion has been met, a reporting entity should consider whether the investment amount reflects the fair value of the expected cash flows of the beneficial interest or represents some other amount (e.g., is equivalent to an option premium for a residual interest that will have a payoff only if the performance of the underlying assets is other than expected). An initial net investment equal to the fair value of the expected cash flows of a beneficial interest would generally not be considered to have “an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors,” but an initial net investment that is less than that amount may be.

If a beneficial interest meets the definition of a derivative in its entirety and does not qualify for a scope exception, it must be accounted for as a derivative under ASC 815. It should be initially recorded at its fair value and subsequently measured at fair value each reporting period with changes in fair value recognized in earnings.
Beneficial interests that are not derivatives in their entirety should be evaluated to determine whether they contain embedded derivatives that should be accounted for separately. As discussed in ASC 815-15-25-12, that determination should be based on an analysis of the contractual terms of the beneficial interest, which requires an understanding of the nature and amount of assets, liabilities, and other financial instruments that comprise the entire securitization transaction. It also requires that the reporting entity obtain information about the payoff structure and the payment priority of the instrument.
The evaluation of the clearly and closely related criterion in ASC 815-15-25-1(a) can be more complicated for beneficial interests because the contractual terms might not explicitly acknowledge the presence of embedded derivatives. Therefore, a more holistic analysis of whether the securitization vehicle has entered into contracts that introduce new risks not inherent in the asset portfolio or how the terms of the beneficial interest relate to the assets and liabilities of the securitization vehicle will be required. ASC 815-15-55-222 through ASC 815-15-55-226A provide examples of how to apply the clearly and closely related criterion to beneficial interests in securitized assets. The evaluation of embedded credit derivative features differs from other risks, as discussed in DH 4.4.6.3.
Following is a list of frequently identified potential embedded derivatives found in beneficial interests that require additional analysis. Interest rate and prepayment features are the most common types of embedded derivatives in investments in securitized financial assets.
  • Embedded prepayment options in the underlying securitized financial assets
  • Embedded put and call options permitting the investor, transferor, or servicer to redeem the beneficial interests
  • Servicer clean-up calls
  • Options that allow the servicer to purchase loans from the securitization trust (e.g., removal of account provisions)
  • Certain explicit derivatives that the securitization vehicle enters into, such as written credit default swaps embedded in synthetic collateralized debt obligation structures
In addition, there may be implicit embedded derivatives when the following exist in the beneficial interests:
  • Basis risk from the interest payments of the assets of a securitization entity being based on interest rates (e.g., adjustable rate mortgage based on Treasury rates) that are different from the interest rate underlying the beneficial interests issued (e.g., LIBOR plus a fixed spread)
  • Notional mismatches creating basis risk between the balances of assets and liabilities of the securitization vehicle and derivatives the securitization vehicle has entered into may occur as the underlying mortgage loans are prepaid
  • Differences in the foreign exchange rates associated with the underlying collateral assets and beneficial interests issued
If there is any potential shortfall of cash flows that will be generated by the assets and derivatives held by a trust funding the payment of the beneficial interests (excluding certain credit losses), no matter how remote, the beneficial interest would contain an embedded component that should be evaluated to determine whether it is a derivative that should be separated. A shortfall may occur if the contractual cash flows from the financial instruments in the vehicle (excluding certain credit losses) could be insufficient to fund the payments to the beneficial interest holders. Provided the only underlying risk is interest rate risk, these embedded components should be analyzed under ASC 815-15-25-26(a) to determine whether the cash flow shortfall could result in the investor not recovering substantially all of its initial recorded investment. Similarly, beneficial interests with positive leverage resulting from incremental trust cash flows (i.e., doubling of the initial and the then-market rates of return) should be analyzed under the guidance in ASC 815-15-25-26(b). See DH 4.4.2 for information on the embedded interest rate derivative guidance in ASC 815-15-25-26.
The analysis required by ASC 815-15-25-26 is based on the recorded basis of the instrument. When investors purchase prepayable beneficial interests at a substantial premium, it becomes more likely that the securities contain an embedded derivative that should be accounted for separately because the hybrid financial instrument is more likely to be contractually settleable in a way that the investor would not recover substantially all of its initial recorded investment. Question DH 4-17 discusses whether an option in an embedded derivative should be accounted for separately.
Question DH 4-17
A mortgage-backed security (MBS) issuer has the option to call the securities once the number of underlying loans falls below 200. Is the option an embedded derivative that should be accounted for separately?
PwC response
Probably not. ASC 815-15-25-37 through 15-39 states that an option that only provides the issuer the right to accelerate the settlement of the debt does not require an assessment under ASC 815-15-25-26(b). Additionally, the option would not be considered an option that is only contingently exercisable under ASC 815-15-25-41 as the number of loans underlying the MBS will eventually reduce to below 200 over the term of the security. As a result, this option would not need to be assessed under the embedded derivative guidance in ASC 815-15 unless the instrument was purchased at a significant premium to the redemption price. In that case, it becomes more likely that the securities contain an embedded derivative that should be accounted for separately based on the guidance in ASC 815-15-25-26(a) because the hybrid financial instrument is contractually settleable in a way that the investor would not recover substantially all of its initial recorded investment.

Question DH 4-18 discusses whether beneficial interests contain embedded derivatives that should be accounted for separately.
Question DH 4-18
A reporting entity issues an “inverse floater.” A special purpose entity holding $100 fixed-rate non-prepayable loans issues a $60 Class A beneficial interest that pays floating-rate interest based on LIBOR (with limited exposure to credit losses on the fixed-rate loans) and a $40 Class B residual interest. Do the beneficial interests contain embedded derivatives that should be accounted for separately
PwC response
The Class A beneficial interest can be viewed as a floating-rate security with an interest rate cap (the return of this Class A beneficial interest is capped by the fixed rate on the prepayable loans). Since the floating rate is capped, it is not likely that the Class A beneficial interest contains an embedded derivative under the guidance in ASC 815-15-25-26.
The Class B beneficial interest has an embedded interest rate swap in which it receives a fixed rate and pays a floating rate on the liabilities issued by the SPE (i.e., floating rate beneficial interests). This embedded interest rate swap should likely be separated from the host beneficial interest based on the guidance in ASC 815-15-25-26. If the floating rate rises, it is possible that the cash flows generated by the loans will not support the terms of the Class A beneficial interests. In that case, the Class B investors would not recover all of their principal. In addition, there are interest rate scenarios that could result in investors doubling both their initial rate of return and the market rate of return for the host beneficial interest.

Question DH 4-19 discusses whether a security with a prepayment feature contains an embedded derivative that should be accounted for separately.
Question DH 4-19
An investor purchases an agency asset-backed security with a par amount of $100 for $115. The mortgage loans underlying the security are prepayable at par ($100). Does the security contain an embedded derivative that should be accounted for separately?
PwC response
Yes. If the borrowers in the mortgage loans owned by the securitization entity elect to prepay their mortgages (at par of $100) the day after the investor purchases the asset-backed security, the investor would receive approximately 87% of its initial recorded investment of $115. In that case, an embedded interest rate derivative should be separated based on the guidance in ASC 815-15-25-26(a) because the investor would not receive substantially all of its initially recorded investment. The likelihood that the borrowers will elect to prepay the mortgage loans on the next day is irrelevant to the analysis.

Question DH 4-20 discusses whether a securitized interest contains an embedded derivative that should be accounted for separately.
Question DH 4-20
An investor pays $115 for a securitized interest with a remaining term of four years, par value of $100 and an interest rate of 7% at a time when market rates for instruments of this credit type are 2%. The assets underlying the securitized interest are not prepayable. Does the security contain an embedded derivative that should be accounted for separately?
PwC response
No. Since the assets are not prepayable, the investor is guaranteed (absent a default, which should not be taken into account when performing the analysis in ASC 815-15-25-26(a)) to receive its recorded investment of $115 (through the interest and principal payments) by the maturity of the securitized interest.

4.4.6.2 Beneficial interests in prepayable securitized assets

ASC 815-15-25-33 exempts certain beneficial interests from the ASC 815-15-25-26(b) leverage tests (the double-double test). This exception only applies to embedded derivatives that are tied to the prepayment risk of the underlying prepayable financial assets.

ASC 815-15-25-33

A securitized interest in prepayable financial assets would not be subject to the conditions in paragraph 815-15-25-26(b) if it meets both of the following criteria:

  1. The right to accelerate the settlement of the securitized interest cannot be controlled by the investor.
  2. The securitized interest itself does not contain an embedded derivative (including an interest-rate-related derivative instrument) for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets.

The application of the guidance in ASC 815-15-25-33 depends on when the beneficial interest was issued or acquired. If it was issued or acquired after June 30, 2007 (date specified in DIG Issue B40), then the guidance should be applied regardless of the value the other embedded derivative (other than the prepayment option) is expected to have over its life.
If the beneficial interest was acquired before January 1, 2007, the beneficial interest would be grandfathered from being assessed under ASC 815-15-25-26(b). If the beneficial interest was issued after January 1, 2007 but before June 30, 2007, then the criterion in ASC 815-15-25-33(b) would not be applicable if the other embedded derivative will have a greater than trivial fair value only under extremely remote scenarios (e.g., embedded derivative only has value when an interest rate index reaches a remote level).

4.4.6.3 Embedded credit derivatives

Reporting entities are required to evaluate credit derivative features embedded in beneficial interests in securitized financial assets to determine whether they should be separately accounted for. ASC 815-15-15-9 provides a limited scope exception for embedded credit derivative features created by the transfer of credit risk between tranches as a result of subordination.

ASC 815-15-15-9

The transfer of credit risk that is only in the form of subordination of one financial instrument to another (such as the subordination of one beneficial interest to another tranche of a securitization, thereby redistributing credit risk) is an embedded derivative feature that shall not be subject to the application of paragraph 815-10-15-11 and Section 815-15-25. Only the embedded credit derivative feature created by subordination between the financial instruments is not subject to the application of paragraph 815-10-15-11 and Section 815-15-25. However, other embedded credit derivative features (for example, those related to credit default swaps on a referenced credit) would be subject to the application of paragraph 815-10-15-11 and Section 815-15-25 even if their effects are allocated to interests in tranches of securitized financial instruments in accordance with those subordination provisions. Consequently, the following circumstances (among others) would not qualify for the scope exception and are subject to the application of paragraph 815-10-15-11 and Section 815-15-25 for potential bifurcation:

  1. An embedded derivative feature relating to another type of risk (including another type of credit risk) is present in the securitized financial instruments.
  2. The holder of an interest in a tranche of that securitized financial instrument is exposed to the possibility (however remote) of being required to make potential future payments (not merely receive reduced cash inflows) because the possibility of those future payments is not created by subordination. (Note, however, that the securitized financial instrument may involve other tranches that are not exposed to potential future payments and, thus, those other tranches might qualify for the scope exception.)
  3. The holder owns an interest in a single-tranche securitization vehicle; therefore, the subordination of one tranche to another is not relevant.

Reporting entities should still evaluate other derivatives embedded in beneficial interests to determine whether they should be separated, including instances in which the beneficial interest has an embedded derivative feature relating to another type of risk (e.g., interest rate risk) or, including another type of credit risk. The embedded derivative analysis should be based on both the contractual terms of the interest in securitized financial assets and the activities of the securitizing entity. This analysis requires an understanding of the nature and amount of assets, liabilities, and other financial instruments that compose the securitization, as well as the payoff structure and priorities, as discussed in ASC 815-15-25-12 and ASC 815-15-25-13.
However, as it relates to credit risk, a reporting entity should first look into the securitization vehicle to identify whether there are any credit derivatives. If a new credit risk is added to a beneficial interest by a written credit derivative in the securitization structure (e.g., as is the case with a collateralized debt obligation), the related embedded credit derivative feature is not clearly and closely related to the host contract. We believe the requirement to look into the securitization vehicle applies beyond credit risk; it also applies to any derivative that introduces additional risk to the securitization rather than managing a risk that already exists in the securitization structure.
We believe securitization vehicles that do not contain any derivatives are not affected by this guidance, as illustrated by Case Y in ASC 815-15-55-226, in which the special-purpose entity holds a portfolio of loans that commingle different credit risks. However, there may be embedded derivatives related to non-credit risks that may have to be separated under other provisions in ASC 815. Question DH 4-21 discusses whether a cash collateralized debt obligation with repayment terms based upon the performance of debt securities contains an embedded credit derivative that should be accounted for separately.
Question DH 4-21
In a cash collateralized debt obligation (CDO), a securitization entity issues interests to third parties. The repayment of the principal on the notes is based on the performance of debt securities held by the securitization entity. Does the security contain an embedded credit derivative that should be accounted for separately?
PwC response
Maybe. Since ASC 815-15-15-9 states that credit concentrations in subordinated interests should not be recognized as embedded derivatives, many cash CDOs will not contain an embedded credit derivative because the principal repayment is directly linked to the loans held by the securitization entity (i.e., repayment is based on the credit risk of the loans held by the securitization entity). Reporting entities should analyze the specific facts and circumstances of their arrangements to determine whether there is an embedded credit derivative that requires separate accounting. In addition, an assessment of other embedded derivatives, such as interest and prepayment risk, should be performed.

Question DH 4-22 and Question DH 4-23 discuss whether a synthetic CDO contains an embedded derivative.
Question DH 4-22
In a synthetic CDO, a securitization entity issues interests to third parties. The securitization entity holds highly-rated financial instruments (e.g., US Treasury securities), writes a credit default swap (CDS), and issues notes to third parties. The repayment of principal and interest on the notes is based on the performance of the CDS (and the underlying collateral). Does the security contain an embedded credit derivative that should be accounted for separately?
PwC response
Yes. A credit derivative written by a securitization entity would not be considered clearly and closely related to its host beneficial instrument; therefore, it should be separated by the holder. In addition, an assessment of other derivatives, such as interest and prepayment risk, should be performed.
Question DH 4-23
A reporting entity issues a synthetic CDO. The reporting entity holds $100 of highly-rated collateral, writes a CDS with a notional amount of $20 on referenced credits, and issues notes with a notional amount of $100. Does the security contain an embedded credit derivative that should be accounted for separately?
PwC response
Yes. The extent of synthetic credit is not relevant to the analysis of embedded credit derivatives. See Case AA in ASC 815-15-55-226C and Case AB in ASC 815-15-55-226D for similar examples.

Question DH 4-24 discusses whether a financial guarantee contract is eligible for the scope exception under ASC 815-10-15-58.
Question DH 4-24
A reporting entity issues a credit-linked note (CLN) through a synthetic securitization transaction (the securitization entity holds highly-rated financial instruments, writes a credit default swap, and issues notes to third parties.) A guarantor provides a financial guarantee contract guaranteeing the payment of principal and interest of the CLN. If there is a credit event, the financial guarantor will step in and make payments to the note holders. Is that financial guarantee contract eligible for the scope exception under ASC 815-10-15-58?
PwC response
No. A CLN issued as part of a synthetic securitization contains an embedded derivative requiring separate accounting. Since the financial guarantee contract provides coverage on a derivative instrument, it would not be eligible for the exception in ASC 815-10-15-58.
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