FASB Separating the Embedded Derivative from the Host Contract

FASB: Separating the Embedded Derivative from the Host Contract

Derivatives Implementation Group

Statement 133 Implementation Issue No. B1

Title: Embedded Derivatives: Separating the Embedded Derivative from the Host Contract
Paragraph references: 12, 60
Date cleared by Board: June 23, 1999
Date revision posted to website: March 14, 2006
Affected by: FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments
(Revised February 16, 2006)

QUESTION

An entity (Company A) issues a 5-year "debt" instrument with a principal amount of $1,000,000 indexed to the stock of an unrelated publicly traded entity (Company B). At maturity, the holder of the instrument will receive the principal amount plus any appreciation or minus any depreciation in the fair value of 10,000 shares of Company B, with changes in fair value measured from the issuance date of the debt instrument. No separate interest payments are made. The market price of Company B shares to which the debt instrument is indexed is $100 per share at the issuance date. The instrument is not itself a derivative because it requires an initial net investment equal to the notional amount; however, what is the host contract and what is the embedded derivative composing the hybrid instrument?

RESPONSE

The host contract is a debt instrument because the instrument has a stated maturity and because the holder has none of the rights of a shareholder, such as the ability to vote the shares and receive distributions to shareholders. The embedded derivative is an equity-based derivative that has as its underlying the fair value of the stock of Company B. Paragraph 60 states:

     ...most commonly, a financial instrument host contract will not embody a claim to the residual interest in an entity and, thus, the economic characteristics and risks of the host contract should be considered that of a debt instrument. For example, even though the overall hybrid instrument that provides for repayment of principal may include a return based on the market price...of XYZ Corporation common stock, the host contract does not involve any existing or potential residual interest rights (that is, rights of ownership) and thus would not be an equity instrument. The host contract would instead be considered a debt instrument, and the embedded derivative that incorporates the equity-based return would not be clearly and closely related to the host contract.

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. As a result of the host instrument being a debt instrument and the embedded derivative having an equity-based return, the embedded derivative is not clearly and closely related to the host contract and must be separated from the host contract and accounted for as a derivative by both the issuer and the holder of the hybrid instrument. (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.)

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.