FASB Embedded Derivatives Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument

FASB: Embedded Derivatives: Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument

Derivatives Implementation Group

Statement 133 Implementation Issue No. B15

Title: Embedded Derivatives: Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Instrument
Paragraph references:

12, 18, 21(f), 29(g), 181, 182, 361

Date cleared by Board: May 17, 2000
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

Does paragraph 12 permit an entity to account separately for more than one derivative feature embedded in a single hybrid instrument?

BACKGROUND

Paragraph 12 of Statement 133 requires that an embedded derivative instrument be separated from the host contract and accounted for as a derivative instrument pursuant to the Statement if certain criteria are met 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.) The embedded derivative provisions of Statement 133 do not provide explicit guidance regarding hybrid instruments that contain more than one embedded derivative feature and how such embedded features should be accounted for. Certain of the example hybrid instruments presented in Section 2 of Appendix B of Statement 133, “Examples Illustrating Application of the Clearly-and-Closely-Related Criterion to Derivative Instruments Embedded in Hybrid Instruments,” contain more than one embedded derivative feature (refer to Examples 15 and 16 regarding range floaters and ratchet floaters, respectively), but none of those multiple embedded derivatives require separate accounting.

RESPONSE

No, paragraph 12 does not permit an entity to account separately for more than one derivative feature embedded in a single hybrid instrument. If a hybrid instrument contains more than one embedded derivative feature that would individually warrant separate accounting as a derivative instrument under paragraph 12, those embedded derivative features must be bundled together as a single, compound embedded derivative instrument that would then be bifurcated and accounted for separately from the host contract under Statement 133 unless a fair value election is made pursuant to Statement 155.

  • An entity is not permitted to separate a compound embedded derivative instrument into components representing different risks (for example, based on the risks discussed in paragraphs 21(f) and 29(g)) and then account for those components separately.

  • If a compound embedded derivative instrument is comprised of multiple embedded derivative features that all involve the same risk exposure (for example, the risk of changes in market interest rates, the creditworthiness of the obligor, or foreign currency exchange rates), but those embedded derivative features differ from one another by including or excluding optionality or by including a different optionality exposure, an entity is also not permitted to separate that compound embedded derivative instrument into components that would be accounted for separately.

Either all or a proportion of a compound embedded derivative that is accounted for separately may be designated as the hedging instrument; however, an entity is not permitted to designate any of the individual components of a compound embedded derivative as a hedging instrument. Additionally, hybrid financial instruments that are elected to be accounted for in their entirety at fair value pursuant to Statement 155 cannot be used as a hedging instrument in a Statement 133 hedging relationship. Such guidance is consistent with the prohibition against separating a freestanding compound derivative into components representing different risks (refer to paragraph 18). Paragraph 361 of Statement 133 indicates that the rationale for prohibiting the separation of a compound derivative into dissimilar components is due, in part, to fair value measurement complications and the potential weakening of effectiveness tests.

If some of the embedded derivative features in a hybrid instrument are clearly and closely related to the economic characteristics and risks of the host contract, those embedded derivative features should not be included in the compound embedded derivative instrument that is bifurcated from the host contract and separately accounted for.

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.