FASB Initial Net Investment

FASB: Initial Net Investment

Derivatives Implementation Group

Statement 133 Implementation Issue No. A1

Title: Definition of a Derivative: Initial Net Investment
Paragraph references: 6(b), 8, 12, 57(b), 255–258
Date cleared by Board: June 23, 1999
Date latest revision posted to website: March 14, 2006
Affected by: FASB Statements No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, and No. 155, Accounting for Certain Hybrid Financial Instruments
(Revised February 16, 2006)

QUESTION

If an entity enters into a forward contract that requires the purchase of 1 share of an unrelated company's common stock in 1 year for $110 (the market forward price) and at inception the entity elects to prepay the contract pursuant to its terms for $105 (the current price of the share of common stock), does the contract meet the criterion in paragraph 6(b) related to initial net investment and therefore meet the definition of a derivative for that entity? If not, is there an embedded derivative that warrants separate accounting?

RESPONSE

Paragraph 6(b) of Statement 133 specifies that a derivative requires either no initial net investment or a smaller initial net investment than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. If no prepayment is made at inception, the contract would meet the criterion in paragraph 6(b) because it does not require an initial net investment but, rather, contains an unexercised election to prepay the contract at inception. Paragraph 8 further clarifies paragraph 6(b) and states that a derivative instrument does not require an initial net investment in the contract that is equal to the notional amount or that is determined by applying the notional amount to the underlying. If the contract gives the entity the option to "prepay" the contract at a later date during its 1-year term (at $105 or some other specified amount), exercise of that option would be accounted for as a loan that is repayable at $110 at the end of the forward contract's one-year term.

If, instead, the entity elects to prepay the contract at inception for $105, the contract does not meet the definition of a freestanding derivative. Paragraph 8, as amended, indicates that if the initial net investment of the contract (after adjustment for the time value of money) is less, by more than a nominal amount, than the initial net investment that would be commensurate with the amount that would be exchanged to acquire the asset related to the underlying, the characteristic in paragraph 6(b) is met. The initial net investment of $105 is equal to the initial price of the 1 share of stock being purchased under the contract and therefore is equal to the investment that would be required for other types of contracts that would be expected to have a similar response to changes in market factors. That is, the initial net investment is equal to the amount that would be exchanged to acquire the asset related to the underlying.

However, the entity must assess whether that nonderivative instrument contains an embedded derivative that, pursuant to paragraph 12, requires separate accounting as a derivative unless a fair value election is made pursuant to Statement 155. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.) In this example, the prepaid contract is a hybrid instrument that is composed of a debt instrument as the host contract (that is, a loan that is repayable at $110 at the end of the forward contract’s 1-year term) and an embedded derivative based on equity prices. The host contract is a debt instrument because the holder has none of the rights of a shareholder, such as the ability to vote the shares and receive distributions to shareholders. (Refer to paragraph 60 of Statement 133.) Unless the hybrid instrument is remeasured at fair value with changes in value recorded in earnings as they occur, the embedded derivative must be separated from the host contract because the economic characteristics and risks of a derivative based on equity prices are not clearly and closely related to a debt host contract, and a separate instrument with the same terms as the embedded derivative would be a derivative subject to the requirements of Statement 133.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.