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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
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?
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.
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