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3.4 Embedded derivatives
Publication date: 20 Jul 2016
us Utilities guide
Certain contracts that do not meet the definition of a derivative in their entirety may contain pricing elements, other provisions, or components that are embedded derivatives. For example, utilities and power companies routinely enter into compound contracts for the sale or purchase of multiple products (such as energy, capacity, and renewable energy credits). As further discussed in UP 1, the accounting guidance provides a logical approach for the evaluation of this type of contract. A contract that is not a derivative in its entirety should be assessed to determine if it includes certain components that require separation and accounting as derivatives. The following section discusses the key items to consider in evaluating potential embedded derivatives in a commodity agreement. Key terms used in this section are described in Figure 3-10.
Figure 3-10
Embedded derivative-related terms
Embedded derivative-related terms
Term |
Definition |
Embedded derivative (ASC 815-10-20) |
Implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by a contract in a manner similar to a derivative instrument. |
Hybrid instrument (ASC 815-10-20) |
A contract that embodies both an embedded derivative and a host contract. |
Host contract |
The base financial instrument or other contract, excluding the embedded derivative. Host contract is not explicitly defined in ASC 815. |
See DH 3 for further information on identifying and accounting for embedded derivatives in general. This section focuses on matters of particular interest in the evaluation of common commodity contracts.
Question 3-27
Should a reporting entity perform an embedded derivative analysis on a contract that is being accounted for under the normal purchases and normal sales scope exception?
Should a reporting entity perform an embedded derivative analysis on a contract that is being accounted for under the normal purchases and normal sales scope exception?
PwC response
No. ASC 815-15-15-4 states that a contract that meets the definition of a derivative in its entirety but qualifies for the normal purchases and normal sales scope exception should not be assessed for embedded derivatives. See UP 3.3.1 for information on how to evaluate whether a contract qualifies for the normal purchases and normal sales scope exception.
3.4.1 Assessing embedded versus freestanding elements
Prior to assessing whether the contract is a derivative or includes any embedded derivatives, a reporting entity should consider whether there are any elements of the contract that are freestanding and should thus be accounted for separately. ASC 815 may still apply under either circumstance, but the application would be different. A freestanding financial instrument is defined in ASC 815.
Definition from ASC 815-10-20
Freestanding Contract: A freestanding contract is entered into either:
- Separate and apart from any of the entity’s other financial instruments or equity transactions
- In conjunction with some other transaction and is legally detachable and separately exercisable.
Therefore, although a derivative instrument may be written into the same contract as another instrument (e.g., in a power contract), it is considered embedded only if it cannot be legally separated from the host contract and transferred to a third party. In contrast, features that are written in the same contract, but that may be legally detached and separately exercised would be considered attached, freestanding derivatives rather than embedded derivatives by both the writer and the holder. These freestanding derivatives would be accounted for separately, eliminating any need to evaluate them under the ASC 815 guidance on embedded derivatives.
This section addresses embedded derivatives and does not further discuss the accounting for freestanding instruments. See DH 3.1.1.1 for further information on evaluating whether an instrument is freestanding or embedded.
3.4.2 Framework for evaluating the separation of embedded derivatives from the host contract
In accordance with ASC 815-15-25-1, a derivative that is embedded in a nonderivative host is separated from the host and accounted for as a derivative only if all of the following criteria are met:
Excerpt from ASC 815-15-25-1
- The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
- 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.
- 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.
Factors to consider in applying these criteria are summarized in this section.
ASC 815-15-25-1(a) — is the potential embedded derivative clearly and closely related to the host contract?
The reporting entity needs to evaluate whether the economic characteristics and risks of the embedded derivative are clearly and closely related to the host contract. This evaluation is performed only once at the time the hybrid instrument is originated or acquired and should be performed separately for any potential embedded derivative. Typically, this evaluation is one of the most judgmental issues in determining whether bifurcation of the hybrid contract is required. UP 3.4.3 provides additional guidance for applying the clearly and closely related criterion to a commodity contract.
ASC 815-15-25-1(b) — is the contract carried at fair value in its entirety?
In assessing commodity contracts to determine whether they contain embedded derivatives that require separation, the reporting entity should assess whether the contract is carried at fair value in its entirety. If so, no further evaluation of potential embedded derivatives is required because the value of any embedded derivative should be incorporated in the overall valuation of the instrument. For example, a pricing feature that is unrelated to natural gas prices in a natural gas option contract accounted for as a derivative would not require separate accounting because the impact of the pricing feature is incorporated into the fair value of the overall option.
ASC 815-15-25-1(c) — would the potential embedded derivative meet the definition of a derivative on a stand-alone basis?
The reporting entity should evaluate whether the separate product, component, or feature would be a derivative on a stand-alone basis. See UP 3.2 for further information on the definition of a derivative and UP 3.6 for considerations in evaluating specific types of commodity contracts. If the potential embedded derivative would not meet the definition of a derivative, no further analysis is required.
Does a scope exception apply?
If all of the criteria are met, the reporting entity would separate and account for the embedded derivative at fair value. However, prior to separation of the embedded derivative, the reporting entity should consider whether one of the exceptions to ASC 815 applies. If an exception applies, and is elected (if applicable), no separation is required. See UP 3.3 for further information on ASC 815 scope exceptions applicable to commodity derivative contracts.
3.4.2.1 Considering multiple embedded derivatives
The bifurcation analysis for a hybrid instrument often becomes increasingly challenging when it involves more than one embedded derivative. For example, a power purchase agreement may include features related to natural gas and power, which would both be derivatives on a stand-alone basis. When there are multiple embedded derivatives, the accounting should generally follow the guidance for compound derivatives in ASC 815-15-25-7 through 25-10.
See DH 3.3.3 for information on factors to consider when a contract includes more than one embedded derivative. See DH 3.7 for information on other accounting considerations for hybrid instruments, including discussion of the method for allocating basis between the host and a separated embedded derivative.
3.4.3 Evaluating whether the potential embedded derivative is clearly and closely related to the host contract in a power purchase agreement
Utilities and power companies often enter into power purchase or other agreements that include multiple products and/or services. For example, a contract may require the delivery of capacity, energy, and other items such as ancillary services or renewable energy credits. Typically, this type of contract does not meet the net settlement criterion in its entirety; therefore, further evaluation under the embedded derivative guidance is required. The evaluation of whether the products are clearly and closely related is a key question in the analysis.
In accordance with ASC 815-15-25-1, the determination of whether the embedded derivative is clearly and closely related to the host contract should be based on an analysis of economic characteristics and risks of the potential embedded derivative and host contract. Said differently, the clearly and closely related criterion considers whether the attributes of the derivative behave in a manner similar to the attributes of the host contract. The economic characteristics and risks are generally measured by reference to the cost or market value of the derivative and host.
In evaluating the application of clearly and closely related to a typical power purchase agreement, in general, we believe that separate products delivered in a single contract will not qualify as clearly and closely related (and thus further evaluation of whether the embedded derivative should be separated is required). This conclusion is based on the following primary factors:
- Separate products
The concept of clearly and closely related in ASC 815-15 is focused on pricing features that change the cash flows of an arrangement and are expected to settle concurrently with settlement of the host contract. The ASC 815-15 guidance generally does not address contracts with multiple products or services. However, the risks and characteristics of a contract with multiple products or services that have different deliverables and settlement dates (e.g., timing of delivery of energy may not coincide with delivery of ancillary services or renewable energy credits) are not analogous to a contract with cash flow variations due to pricing features. Furthermore, for contracts with more than one deliverable (e.g., debt and equity, such as convertible debt) the embedded derivative typically is not clearly and closely related.
In a power purchase agreement containing multiple products, the buyer is paying for delivery of more than one item. Although the prices of the products in the contract may be interrelated (i.e., there could be some benefit by bundling the products into one contract as compared to stand-alone selling prices), the price of one product does not represent a price adjustment but instead represents a payment for a different deliverable. - Periodic settlement
A contract for more than one physically delivered product requires settlement (payment) for each of those products on a periodic basis. Each product represents a different cash flow under the contract and the settlement of one product does not result in settlement of the remaining products or obligations under the contract. ASC 815-15-25-41 provides an example of call and put options that do not accelerate the repayment of principal on a debt instrument but rather force a cash settlement that is equal to the price of the option at the date of exercise. The guidance in that paragraph states that the option, which has an independent settlement feature, would not be considered clearly and closely related to the debt host. - Nonfinancial products
ASC 815 provides limited guidance on how to perform this analysis for nonfinancial contracts; almost all of the application examples in ASC 815 pertain to financial hybrid instruments. In discussing one of the few nonfinancial hybrid examples, the response to DIG Issue B14, Embedded Derivatives: Purchase Contracts with a Selling Price Subject to a Cap and a Floor (DIG Issue B14), states, in part:
However, when deciding whether the economic characteristics and risks of the embedded derivative are clearly and closely related to the host contract for other nonfinancial hybrid contracts, it may not be appropriate to analogize to the guidance in paragraph 61 [now ASC 815-15-25-23 to 25-51]. The guidance in paragraph 61 is not meant to address every possible feature that may be included in a hybrid instrument but, instead, that paragraph covers common features present in financial hybrid contracts.
The DIG Issue B14 response indicates that, in general, the guidance provided on clearly and closely related in ASC 815 is applicable for financial hybrid contracts but not necessarily for nonfinancial hybrid contracts.
Based on these factors, we believe that multiple deliverables in a single contract are usually not clearly and closely related to the nonderivative host contract; therefore, further evaluation is required to determine if separation is required from the host contract (see UP 3.4.2). See further discussion of the application of the embedded derivative guidance to power contracts in Question 3-30 and the simplified examples that follow.
Question 3-28
How does the interpretation of clearly and closely related for embedded derivatives relate to the clearly and closely related criterion applied in the normal purchases and normal sales scope exception?
How does the interpretation of clearly and closely related for embedded derivatives relate to the clearly and closely related criterion applied in the normal purchases and normal sales scope exception?
PwC response
ASC 815-10-15-30 through 15-34 establish a qualitative and quantitative approach for assessing whether a pricing feature is clearly and closely related in application of the normal purchases and normal sales scope exception. However, it also clarifies that the phrase conveys a different meaning than in the embedded derivative analysis.
Excerpt from ASC 815-10-15-31
The phrase not clearly and closely related…with respect to the normal purchases and normal sales scope exception is used to convey a different meaning than in paragraphs 815-15-25-1(a) and 815-15-25-16 through 25-51 with respect to the relationship between an embedded derivative and the host contract in which it is embedded.
In general, the normal purchases and normal sales scope exception establishes a more structured approach compared to the analysis performed in the embedded derivative evaluation. Specifically, the clearly and closely related analysis for purposes of applying the normal purchases and normal sales scope exception requires a qualitative and quantitative analysis of pricing features within the contract. To apply the exception, at contract inception the price adjustment should be expected to impact the price in a manner comparable to the outcome that would be obtained if, at each delivery date, the parties were to reprice the contract under then-existing conditions. In contrast the analysis of potential embedded derivatives does not require explicit comparison of the pricing but instead focuses on the overall economic risks and characteristics of the potential embedded derivative and the host.
See UP 3.3.1 for further discussion of the normal purchases and normal sales scope exception, including application of the exception to embedded derivatives.
Question 3-29
How is the host contract determined when assessing a hybrid contract?
How is the host contract determined when assessing a hybrid contract?
PwC response
Identification of the host contract is a key question when determining whether a hybrid instrument requires bifurcation. There is little specific guidance on the identification of the host and we are aware that different methodologies are discussed. For example, some believe that the host contract should represent the “predominant characteristic(s)” within the hybrid, while others look to separate the derivative and nonderivative elements.
The Basis for Conclusions of FAS 133 discusses some of the FASB’s considerations in developing the hybrid approach. The FASB considered evaluating potential embedded derivatives based on predominant characteristics or yield, but concluded that those approaches would scope in instruments that were not the intent of the guidance and may not be operational. The FASB also initially considered requiring that the entire instrument be measured at fair value when a contract included both derivative and nonderivative elements. However, the FASB decided to only require the embedded derivative to be measured at fair value, except in limited circumstances, such as when the embedded derivative cannot be reliably identified and measured. The FASB believed that this approach was most consistent with the objective of measuring derivative instruments at fair value.
In evaluating the appropriate accounting, we further consider the guidance of ASC 815-15-05-1.
Excerpt from ASC 815-15-05-1
The effect of embedding a derivative instrument in another type of contract (the host contract) is that some or all of the cash flows or other exchanges that otherwise would be required by the host contract, whether unconditional or contingent on the occurrence of a specified event, will be modified based on one or more underlyings.
We also consider the accounting for the host contract discussed in ASC 815-15-25-54.
If an embedded derivative is separated from its host contract, the host contract shall be accounted for based on GAAP applicable to instruments of that type that do not contain embedded derivatives.
Considering the FASB’s objectives and related guidance, we believe the appropriate approach for determining the host contract is to identify those elements (cash flows) of a contract that meet the definition of a derivative separately from the nonderivative elements (cash flows) of the contract. Any nonderivative elements should be considered together as a single host contract and the potential derivative elements should be evaluated for separation from the single host contract. Because the host contract follows other applicable U.S. GAAP, we do not believe any of the derivative elements can be the host contract. This approach is consistent with the FASB’s overall objectives of measuring only derivative elements at fair value.
Question 3-30
Is energy and capacity considered clearly and closely related for purposes of assessing whether a hybrid contains an embedded derivative?
Is energy and capacity considered clearly and closely related for purposes of assessing whether a hybrid contains an embedded derivative?
PwC response
Generally, no. As described above, we believe that the clearly and closely related exception for embedded derivatives was not intended to apply to contracts with separate products and deliverables with different pricing and settlements. Therefore, when evaluating capacity and energy combined in the same contract, we generally believe that they are not clearly and closely related (with a limited exception if these products are bundled in the area of the United States where they are being transacted).
Some may hold an alternative view that energy and capacity, or other products that could be combined in a power purchase agreement, should be subject to a quantitative and/or qualitative evaluation when performing the clearly and closely related analysis. Because of the nature of the markets (e.g., pricing of the products is sometimes correlated with each other), the source of the products (e.g., energy and capacity originating from the same plant or location), or the interrelationship within the contract (e.g., default provisions, pricing), proponents of this view believe that a clearly and closely related conclusion could be reached based on this type of analysis.
However, the intent (and examples that demonstrate the objective) of the ASC 815 guidance on clearly and closely related is to provide reporting entities with a practical accommodation for prepayment, pricing, and other features that modify the cash flows of a host contract; it is not to combine different products within the same contract. Therefore, we believe that separate deliverables under a contract are generally not clearly and closely related when the contract includes separate performance obligations, separate pricing, or multiple settlement dates for the products. In many cases, the energy portion within these contracts meets the definition of a derivative and so separate accounting for the energy and capacity portions of the contract would result.
3.4.3.1 Application examples — embedded derivative evaluation
The following simplified examples are provided to illustrate the evaluation of whether a contract contains an embedded derivative that requires separation.
EXAMPLE 3-24
Embedded derivative analysis — power purchase agreement
Embedded derivative analysis — power purchase agreement
On May 10, 2015, Ivy Power Producers (IPP) enters into a one-year agreement to sell an hourly amount of 100 MWs of capacity and energy, during on-peak hours, to Rosemary Electric & Gas Company (REG). The contract includes a capacity fee as well as separate charges for energy, start-up, and other ancillary charges.
REG operates in a market where energy and capacity are sold as separate products and there is no spot market for bundled energy and capacity. Furthermore, although there is bilateral activity in capacity, there is no active spot market and stand-alone physical capacity contracts do not meet the definition of a derivative instrument.
Does the arrangement contain an embedded derivative?
Analysis
The contract is not a derivative in its entirety because it does not meet the criteria of net settlement. The results of the analysis of potential embedded derivatives are summarized below.
Economic characteristics of the embedded are not clearly and closely related to the host |
Not applicable. Capacity is not a derivative on a stand-alone basis and would not be accounted for as a derivative. The capacity component is determined to be the host contract. |
Met. The energy is not clearly and closely related to the capacity. |
Hybrid instrument is not remeasured at fair value under otherwise applicable U.S. GAAP |
Met. The power purchase agreement is not measured in its entirety at fair value under other applicable U.S. GAAP. |
Met. The power purchase agreement is not measured in its entirety at fair value under other applicable U.S. GAAP. |
A separate instrument with the same terms as the embedded derivative would be a derivative instrument subject to ASC 815 |
Not met. There is no active spot market for capacity and a stand-alone capacity contract would not be accounted for as a derivative in this market. |
Met. There is an active spot market for power and management concludes that a stand-alone contract with the same terms would be accounted for as a derivative. If the normal purchases and normal sales scope exception is elected, the power component would not require separation. |
In evaluating the clearly and closely related criterion, the energy is not clearly and closely related to the capacity given it is a separate deliverable with separate settlement dates. Furthermore, the delivery of energy does not adjust the cash flows related to capacity. Consistent with the discussion in UP 3.4.3, we believe that separate products combined in the same contract would generally not qualify as clearly and closely related to the host contract. As a result, in this example, the energy component should be separated from the capacity and accounted for as a derivative instrument, unless the energy component of the contract qualifies and the party elects the normal purchases and normal sales scope exception. The start-up and other ancillary costs would also not qualify as an embedded derivative under a similar analysis because these features, when present within a separate instrument, would not meet the definition of a derivative.
In addition, the analysis would not change even if the products were priced together within the contract (i.e., one bundled fixed price for both the energy and capacity). The contract as a whole would still not meet the net settlement criterion (i.e., there are no active spot markets for the bundled contract of energy and capacity) and evaluation of the separate capacity and energy components would be required. The bundled pricing would not change the evaluation completed as outlined above. See UP 1 and DH 3.7.1 for information on allocating fair value to a derivative that is separated from the host contract.
Question 3-31
Would a fully prepaid commodity agreement contain an embedded derivative that would require separation from the host?
Would a fully prepaid commodity agreement contain an embedded derivative that would require separation from the host?
PwC response
Generally yes. A fully prepaid commodity agreement would not meet the definition of a derivative instrument as the full amount of the agreement has already been paid and as such, the contract has an initial net investment. As a result, an entity should consider whether the agreement contains an embedded derivative that would require separate accounting. The prepayment of the commodity for the full term of the agreement would represent a financing or loan and thus the prepaid commodity agreement would be considered a debt host contract. However, the loan is being repaid through the delivery of a commodity (e.g., natural gas or crude oil) and therefore the interest rate on the loan is effectively tied to the price of the commodity. As such, the economic characteristics and risks of the potential embedded derivative (e.g., natural gas or crude oil pricing) are not clearly and closely related to those of the host loan contract (i.e., interest rates). The embedded derivative would require separation from the debt host and should be accounted for at fair value, unless the contract qualifies for and is designated under the normal purchases and normal sales scope exception.
Question 3-32
Would a contract that has an index relating to the transportation of the commodity be considered clearly and closely related?
Would a contract that has an index relating to the transportation of the commodity be considered clearly and closely related?
PwC response
It depends. The clearly and closely related criterion considers whether the attributes of the derivative behave in a manner similar to the attributes of the host contract. One way the economic characteristics and risks can be measured is by reference to the cost of the derivative and host. As a result, if the index included in the pricing of the commodity is based on the cost to produce the commodity, the index would still be considered to be clearly and closely related as long as there is no leverage introduced in the agreement. For example, if a contract to purchase coal includes a gasoline price index that represents the transportation cost of moving the coal from the coal mine to the market, the gasoline price index would not require bifurcation if it can be demonstrated that the index represents the transportation cost of taking the coal to the market and does not introduce any extraneous impact from changes in gasoline prices or leverage. Similarly, for a biomass facility that burns wood for fuel and has a pricing component tied to diesel, we would deem a potential embedded derivative tied to the price of diesel to be clearly and closely related to the host contract to purchase power. This is because diesel is a key component of the price of the transportation to get the wood to the delivery location. In contrast, a host supply contract for the purchase of natural gas, with pricing based on the Consumer Price Index, would likely not capture the overall economic risk of natural gas price changes to enable application of the clearly and closely related criteria.
EXAMPLE 3-25
Embedded derivative analysis — coal contract with price inflation
Embedded derivative analysis — coal contract with price inflation
Ivy Power Producers (IPP) enters into a coal purchase contract that has terms requiring delivery of 100 tons of coal per week for 5 years with initial pricing fixed at $90 per ton. The coal is delivered to a plant near the Powder River Basin from a specified mine. IPP has determined the contract does not meet the definition of a derivative because there is no method of net settlement. A price inflation clause in the agreement provides that the price per ton will be increased on each anniversary date by the change in a published market index for coal of the same quality as the coal in the Powder River Basin.
Is there an embedded derivative that needs to be bifurcated?
Analysis
The executory contract for the purchase of coal is the host contract. The price inflator would be a derivative on a stand-alone basis because there is a notional amount (100 tons of coal per week for 5 years), an underlying (the price of Powder River Basin coal), no initial net investment in the contract, and a cash settlement representing the price inflator. The economic characteristics of the published market index bear a close economic relationship to the host contract (the purchase of coal from a source in the Powder River Basin). The pricing in the contract that includes the adjustment based on the change in the published market index would be expected to be closely correlated with the pricing at Powder River Basin. As such, the embedded derivative would not require separation from the host contract. If the inflator was based on a broader coal index that did not reflect the economic conditions of the region (e.g., the coal index was based on all of North and South America, but the region where the coal is sourced from is Powder River Basin), IPP would need to perform a detailed analysis to demonstrate that the economic characteristics and risks of the inflator were clearly and closely related to those of the host contract.
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