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4.8.1 Issuer and investor asymmetry

Although the requirement to separate an embedded derivative from a host contract applies to both parties to a contract (i.e., both the issuer and the holder of a hybrid instrument), the two parties might reach different conclusions. The following sections discuss transactions when this asymmetry is likely to occur. Convertible debt

An investor that holds a debt security that is convertible into shares of a public company’s common stock must separate the embedded conversion option from the host contract because it would be subject to the requirements of ASC 815 if it were a freestanding derivative. However, the issuer may qualify for the scope exception in ASC 815-10-15-74(a) for certain contracts involving an issuer’s own equity. In that case, the issuer would not have to separate the embedded conversion option. See DH 3.3 and FG 5 for information on the scope exception for certain contracts involving an issuer’s own equity. Equity-indexed life insurance

An equity-indexed life insurance contract links term-life coverage with an investment feature. The surrender feature provides the policyholder with a contingent equity return that is not clearly and closely related to the host contract, as discussed in ASC 815-15-55-75; therefore, the insurance company would have to separately account for the embedded derivative. However, if the holder accounts for an equity-indexed life insurance contract under the guidance in ASC 325-30, Investments—Other, Investments in Insurance Contracts, it is not subject to ASC 815 and therefore the holder would not separate the embedded derivative. See DH 3.2.9 for information on the scope exception for investments in life insurance contracts and LI 5.4 for information on the accounting for investments in life insurance contracts.

4.8.2 Timing and frequency of the embedded derivative assessment

The analysis of whether an embedded derivative is clearly and closely related to its host contract is generally performed either on the date that the hybrid instrument is issued or on the date that the reporting entity acquires the instrument. An investor that acquires a hybrid instrument in the secondary market or in a business combination could potentially reach a different conclusion with regard to the separation of an embedded derivative than the issuer or the original investor, since each may perform their respective analyses on different dates and under potentially different market conditions. For example, the initial investor of the instrument at par may reach a different conclusion than a reporting entity that acquires a hybrid instrument in the secondary market at a premium or discount with regard to the leverage tests required in ASC 815-15-25-26 when assessing an interest rate host with embedded interest rate features. That is, the initial investor may have concluded that an embedded derivative was clearly and closely related to the host contract, whereas a subsequent holder may conclude otherwise, or vice versa.
While the analyses of the clearly and closely related criterion in ASC 815-15-25-1(a) and the embedded foreign currency derivative guidance in ASC 815-15-15-10 are generally one-time assessments for each holder of the hybrid instrument, the remaining criteria in ASC 815-15-25-1 require an ongoing assessment by each holder each reporting period. Because ASC 815-15-25-1(c) requires a decision about whether a separate instrument with the same terms as the embedded derivative would qualify as a derivative, it follows that the assessment of whether an embedded derivative should be separated must also be applied at the inception of the hybrid instrument and over its life. Although a similar reassessment argument may be made regarding the criterion in ASC 815-15-25-1(b), it is uncommon for the measurement attribute of a hybrid instrument to change absent a change in accounting principle that provides specific transition guidance.
There are a number of circumstances under which a reporting entity should reassess embedded derivatives in a hybrid instrument. These include the following:
  • A public offering of equity instruments may cause an embedded conversion option related to that instrument to have the characteristic of net settlement because the underlying instrument is readily convertible to cash pursuant to ASC 815-10-15-119.
  • The classification of an embedded derivative may no longer meet the ASC 815-10-15-74(a) scope exception because of a change in circumstances causing the embedded derivative, if freestanding, to be reclassified to a liability from equity under the guidance in ASC 815-40.
  • A hybrid instrument may be legally modified in a manner that triggers a new basis event.

4.8.3 Multiple embedded derivative features

ASC 815-15-25-7 provides guidance on separating multiple embedded derivatives from a single hybrid instrument (e.g., a call option and a conversion option from a convertible debt security).

ASC 815-15-25-7

If a hybrid instrument contains more than one embedded derivative feature that would individually warrant separate accounting as a derivative instrument under paragraph 815-15-25-1, those embedded derivative features shall be bundled together as a single, compound embedded derivative that shall then be bifurcated and accounted for separately from the host contract under this Subtopic unless a fair value election is made pursuant to paragraph 815-15-25-4.

Separating embedded derivatives from a hybrid instrument often becomes more complex when there is more than one embedded derivative. Embedded derivatives that are clearly and closely related (and as a result are not separated) may have an impact on the valuation of the embedded features that are separated. Those embedded derivatives should not be included in the compound embedded derivative instrument that is separated from the hybrid instrument. The host contract and the remaining embedded derivatives should be accounted for based on GAAP applicable to similar host contracts of that type.
Each embedded derivative should be analyzed separately; however, there may be circumstances in which it is reasonable to analyze multiple embedded derivatives together. Regardless of the approach taken, we believe that a reporting entity should (1) contemporaneously document the method selected and the factors considered in electing that method and (2) consistently apply that method over time.
Once a conclusion is reached that multiple derivative features must be separated, the value of the compound derivative must be based on one unit of account rather than determining separate fair value measurements for each embedded derivative component and adding them together. A separate unit of account method is inconsistent with ASC 815-15-25-7 and may produce an inaccurate valuation result, since multiple derivatives within a single hybrid instrument likely affect each other’s fair values.
Question DH 4-31 discusses whether the sum of the fair values of a separated embedded derivative and the remaining host contract equal an amount that is greater or less than the fair value of the hybrid instrument taken as a whole.
Question DH 4-31
Can the sum of the fair values of a separated embedded derivative and the remaining host contract equal an amount that is greater or less than the fair value of the hybrid instrument as a whole?
PwC response
No. The sum of the values of the separated embedded derivatives and the remaining instrument should equal the value of the hybrid instrument as a whole.

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