Search within this section
Select a section below and enter your search term, or to search all click Financing transactions
Favorited Content
1.6 Embedded components within debt instruments
Publication date: 31 Dec 2022
us Financing guide
Many debt instruments include embedded components. A borrower should evaluate these embedded components to determine whether they are embedded derivatives within the scope of ASC 815 that should be separately carried at fair value.
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.
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:
a. 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.
b. 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.
c. 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.)
The most common features embedded in a debt instrument are put and call options. A put option allows a lender to demand repayment, and a call option allows a borrower to repay debt before its maturity date.
1.6.1 Embedded put and call options
Provided a host debt instrument is not accounted for at fair value with changes in fair value recorded in net income, the first step in assessing whether an embedded put or call option should be separately accounted for as a derivative is to determine whether the embedded option would be accounted for as a derivative under the guidance in ASC 815 if it were a freestanding instrument. To do this, a reporting entity should assess whether the embedded put or call option (1) meets the definition of a derivative or (2) qualifies for a scope exception to derivative accounting in ASC 815. Most put and call options embedded in a debt instrument do meet the definition of a derivative and do not qualify for a scope exception to derivative accounting in ASC 815. A put or call option embedded in a host debt instrument meets the net settlement criterion in ASC 815-10-15-83(c) because its settlement results in the delivery of an instrument to its issuer. Thus, the extinguishment of debt as part of the exercise of a call or put option is not considered to be the delivery of an asset to the debtor and the creditor does not receive an asset associated with the underlying. This is true even if the issuer has the option or is required to settle the debt in a variable number of shares with a fair value equal to the strike price, rather than cash. This is because even if settled in a variable number of shares, neither party is required to deliver an asset associated with the underlying of the embedded option. In these situations, changes in the fair value of the shares delivered do not impact the value of the debt and, as such, equity prices are not considered to be an underlying. These put and call options should be evaluated to determine whether they are clearly and closely related to their host debt instrument.
1.6.1.1 Puts and calls—clearly and closely related analysis
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 FG 1-1 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 FG 1-1
Determining whether an embedded put or call option is clearly and closely related to its host debt instrument
Determining whether an embedded put or call option is clearly and closely related to its host debt instrument
See Example FG 1-1 for an illustration of the different analyses for a put option and a term extending option. The example is written from the perspective of an investor; however, an issuer would follow the same guidance.
EXAMPLE FG 1-1
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 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 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.
The put option in Bond A would generally not have to 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 indicates 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; therefore, the term-extending option embedded in Bond B is clearly and closely related.
If the issuer controls the term extension option, it is possible that the investor could be forced into a situation in which the investor does not recover substantially all of their initial net investment (on a present value basis), which would indicate that the term extension option is not clearly and closely related to the host contract. However, consideration should be given to whether the term extension option meets the definition of a derivative or if it would qualify for a scope exception in ASC 815 to determine if it should be bifurcated from the host contract. For host contracts other than debt hosts, ASC 815-15-25-45 requires an analysis to determine whether term extension options should be separated under ASC 815-15-25-1(a).
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 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.
Determine whether the put or call option accelerates repayment of principal of the debt
The reporting entity should first determine whether exercise of the put or call option accelerates the repayment of principal of the debt. ASC 815-15-25-41 provides guidance on put and call options that do not accelerate the repayment of the debt.
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.
Determine the nature of the settlement amount paid upon exercise of put or call option
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 call 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 risk (specifically, the issuer’s credit). If the index is not an interest rate index or credit risk, 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 FG 1-4
Is an embedded put or call option that if exercised, the borrower will pay the fair value of the debt upon exercise considered clearly and closely related to its host?
Is an embedded put or call option that if exercised, the borrower will pay 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. For example, if a debt instrument is callable by the borrower at fair value, a lender may receive substantially less than their initial recorded investment. On the other hand, if the option is a lender-held put option, while the investor would never be forced to receive substantially less than their initial recorded investment, the put option would need to be further evaluated to determine if it is clearly and closely related to the host. However, the option generally would not have a material value because its strike price is equal to the underlying’s fair value.
Determine whether the debt instrument involves a substantial discount or premium
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, a 10% discount or premium is not a bright-line; all relevant facts and circumstances should be considered to determine whether the discount or premium is substantial. For example, if a contingent put or call option is highly likely of becoming exercisable in a short period of time after issuance, a discount or premium of less than 10% could be considered 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, it should be evaluated to determine whether it is contingently exercisable. If it does not involve a substantial premium or discount, it should be further evaluated to determine whether it contains an embedded interest rate derivative that should be separated. See FG 1.6.1.2 for information on how to determine whether a debt host contract contains an embedded interest rate derivative.
Determine whether the 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.
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 or is not otherwise required to be bifurcated under ASC 815-15-25-41 and ASC 815-15-25-42, it should be further evaluated to determine whether it contains an embedded interest rate derivative that should be separated.
1.6.1.2 Analysis of 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 an interest rate or interest rate index.
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:
a. 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).
b. 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 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 ASC 815-15-25-26(a) 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 ASC 815-15-25-26(b) above is not applicable.
Application of the test to determine whether the lender recovers substantially all of its investment
We believe “substantially all” means approximately 90% of the investment. Therefore, if the embedded component in a debt instrument could result in the lender being required to settle the debt instrument 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.
Application of the test to determine whether the lender can double its initial rate of return and double the 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 as discussed in FG 8.4. 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 surrendering 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.
Prior to adoption of ASU 2020-06, convertible debt within the scope of the cash conversion guidance in ASC 470-20 should perform the double-double test before the bond is bifurcated, as described in FG 6.6A. Therefore, when evaluating whether an embedded put or call option should be accounted for separately, the discount created by separating the conversion option should not be considered. This will also be true after the adoption of ASU 2020-06 for convertible debt with a substantial premium. As described in FG 6.6, this guidance requires the premium to be separately recorded in APIC such that the liability would be recorded at its par value. We believe that the evaluation of whether any embedded put or call options should be accounted for separately should be performed prior to the separation between liability and APIC.
Question FG 1-5
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?
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 in the money.
Question FG 1-6
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?
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 basis swap) would have to be accounted for separately under ASC 815.
Question FG 1-7
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?
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 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 basis swap) would have to be accounted for separately under ASC 815.
For consideration of whether interest rate reset features based on SOFR would be required to be bifurcated as an embedded derivative, please refer to DH 4.9.
1.6.1.3 Application examples of embedded interest rate derivatives
Example FG 1-2 illustrates the application of the guidance for determining whether an embedded put and call option should be separated from a debt instrument and accounted for as a derivative to debt puttable upon a change in interest rates. Example FG 1-3, Example FG 1-4 and Example FG 1-5 illustrate this analysis to debt puttable upon a change of control.
EXAMPLE FG 1-2
Debt puttable upon a change in interest rates
Debt puttable upon a change in interest rates
FG Corp issues a fixed-rate debt instrument with a term of five years, at par value. The debt contains a put option that allows the lender to put the debt when there is an increase in the 6-month LIBOR rate of 150 basis points or more, and receive 105% of the debt’s par value.
Is the embedded put option clearly and closely related to the debt host?
Analysis
FG Corp performs the analysis in Figure 1-1 as illustrated below.
After considering the guidance in ASC 815-15-25-26(b), FG Corp would conclude that the debt has an embedded interest rate derivative that should be accounted for separately because it is possible for the investor to earn double the then-current market rate for the host debt instrument and double their initial rate of return. For example, if 6-month LIBOR increases to 151 basis points the day after the debt is issued and the investor puts the debt to the issuer for 105% of par, that could result in the issuer earning more (on an annualized basis) than the then-current market rate of return for the host debt instrument as well as doubling the investor’s initial rate of return.
EXAMPLE FG 1-3
Debt issued at par, puttable upon a change in control
Debt issued at par, puttable upon a change in control
FG Corp issues a fixed-rate debt instrument with a term of five years, at par value. The debt contains a put option that allows the lender to put the debt when there is a change in control (defined in the debt agreement) and receive 105% of the debt’s par value. FG Corp determines that a change in control during the next five years is unlikely.
Is the embedded put option clearly and closely related to the debt host?
Analysis
FG Corp performs the analysis in Figure 1-1 as illustrated below.
Based on the analysis, the embedded put option is considered clearly and closely related to its debt host. It should not be accounted for separately.
EXAMPLE FG 1-4
Debt issued at a premium, puttable upon a change in control
Debt issued at a premium, puttable upon a change in control
FG Corp issues a fixed-rate debt instrument with a term of five years, at 102% of par value. The debt contains a put option that allows the lender to put the debt when there is a change in control (defined in the debt agreement) and receive par value. FG Corp determines that a change in control during the next five years is unlikely.
Is the embedded put option clearly and closely related to the debt host?
Analysis
FG Corp performs the analysis in Figure 1-1 as illustrated below.
Based on the analysis, the embedded put option is considered clearly and closely related to its debt host. It should not be accounted for separately.
EXAMPLE FG 1-5
Debt issued at a discount, puttable upon a change in control
Debt issued at a discount, puttable upon a change in control
FG Corp issues a fixed-rate debt instrument with a term of five years, at 80% of par value. The debt contains a put option that allows the lender to put the debt when there is a change in control (defined in the debt agreement) and receive par value.
Is the embedded put option clearly and closely related to the debt host?
Analysis
FG Corp performs the analysis in Figure 1-1 as illustrated below.
Based on the analysis, the embedded put option is not considered clearly and closely related to its debt host. It should be accounted for separately as a derivative based on the guidance in ASC 815.
1.6.2 Indexed debt instruments
Some debt instruments have embedded components that provide for returns that are indexed to an underlying other than interest rates or the creditworthiness of the reporting entity. For example, a debt instrument may be indexed to the price of the reporting entity’s equity, creditworthiness of a referenced pool of debt securities, commodities such as oil or natural gas, or the S&P 500 index.
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. Embedded components which index a debt instrument to a reporting entity’s own equity often qualify for the scope exception for certain contracts involving a reporting entity’s own equity in ASC 815-10-15-74(a); therefore, these embedded components are generally not separated and accounted for as a derivative.
Many embedded components which index a debt instrument to an index unrelated to the reporting entity (e.g., natural gas, S&P 500) often meet the requirements for derivative separation; therefore, these instruments are often accounted for as a debt host contract and a separate derivative.
If the embedded component is not required to be separately accounted for as a derivative under ASC 815, the guidance in ASC 470-10-25-4 and ASC 470-10-35-4 should be applied to the indexed debt instrument.
If the investor’s right to receive the contingent payment is separable, the proceeds shall be allocated between the debt instrument and the investor’s stated right to receive the contingent payment. The premium or discount on the debt resulting from the allocation shall be accounted for in accordance with Subtopic 835-30.
As the applicable index value increases such that an issuer would be required to pay an investor a contingent payment at maturity, the issuer shall recognize a liability for the amount that the contingent payment exceeds the amount, if any, originally attributed to the contingent payment feature. The liability for the contingent payment feature shall be based on the applicable index value at the balance sheet date and shall not anticipate any future changes in the index value. When no proceeds are allocated originally to the contingent payment, the additional liability resulting from the fluctuating index value shall be accounted for as an adjustment of the carrying amount of the debt obligation.
Inflation bonds are commonly issued indexed debt instruments. In general, inflation in the economic environment for the currency in which a debt instrument is denominated is considered clearly and closely related to a debt instrument; therefore, the indexation to inflation within an inflation bond typically does not meet the requirements for derivative separation. ASC 815-15-55-202 and ASC 815-15-55-203 and Question FG 1-8 provide examples illustrating when an inflation bond should be separated into a derivative and a debt host instrument.
Question FG 1-8
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?
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.
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.
1.6.3 Contingent interest
Some debt instruments pay additional interest only when certain conditions exist. For example, the amount of interest to be paid may be based on a reporting entity’s stock price, credit rating, or dividends declared on a reporting entity’s common stock. Other contingent interest provisions include payment of additional interest contingent on the occurrence of certain events. For example, additional interest is paid to investors upon a change in tax law (e.g., changes in allowable withholding or deductions) that increases the tax obligation of certain investors.
A contingent interest feature that meets the definition of a derivative is considered clearly and closely related to a debt host when indexed solely to interest rates or the reporting entity’s credit risk and other requirements are met. Consistent with the analysis of indexed debt instruments discussed in FG 1.6.2, if the contingent interest feature is based on an index that is unrelated to the reporting entity, the feature should be separated and accounted for as a derivative.
Certain contingent interest provisions that meet the definition of a registration payment arrangement are within the scope of ASC 825-20-15-3. See FG 1.7 for information on registration payment arrangements.
The determination of the likelihood of paying contingent interest should be consistent for book and tax purposes. That is, if a reporting entity determines that the value of a contingent interest feature is not material because the likelihood of payment is remote, then the same assertion should be used when determining if the interest is deductible for tax purposes. See TX 9.4.2 for information on the tax accounting considerations of contingent interest.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
Link copied
