Expand
Resize
Add to favorites
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.

ASC 815-15-25-1

An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:
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. These put and call options should be evaluated to determine whether they are clearly and closely related to their host debt instrument.
See DH 2 for a discussion of the definition of a derivative and DH 3 for a discussion of scope exceptions to ASC 815.

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
See Example DH 4-4 for an illustration of the different analyses for a put option and a term extension option.
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.

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.
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 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 FG 1-4 discusses whether an embedded put or call option that allows a lender or reporting entity to receive the fair value of the debt upon exercise is considered clearly and closely related to its host.
Question FG 1-4
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.
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. 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, 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.

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:
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 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 8.3. 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.
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.

1.6.1.3 Application examples of embedded interest rate derivatives

Example FG 1-1 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 1-2, Example FG 1-3 and Example FG 1-4 illustrate this analysis to debt puttable upon a change of control.
EXAMPLE FG 1-1
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 815-15-25-25(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. 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.
EXAMPLE FG 1-2
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 1-3
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.
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 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. See DH 4 for information on embedded derivatives.
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.

ASC 470-10-25-4

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.

ASC 470-10-35-4

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 in which a debt instrument is issued 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 DH 4-11 provide examples illustrating when an inflation bond should be separated into a derivative and a debt host 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. 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 meet the definition of a registration payment arrangement 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.
Expand

Welcome to Viewpoint, the new platform that replaces Inform. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.

Your session has expired

Please use the button below to sign in again.
If this problem persists please contact support.

signin option menu option suggested option contentmouse option displaycontent option contentpage option relatedlink option prevandafter option trending option searchicon option search option feedback option end slide