FASB Embedded Derivatives Term-Extending Options in Contracts Other Than Debt Hosts
Derivatives Implementation Group
Statement 133 Implementation Issue No. B17
|Title:||Embedded Derivatives: Term-Extending Options in Contracts Other Than Debt Hosts|
|Paragraph references:||12, 61(g)|
|Date cleared by Board:||June 28, 2000|
|Date latest revision posted to website:||June 16, 2006|
|Affected by:||FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments
(Revised June 16, 2006)
Should the guidance in paragraph 61(g) of Statement 133 relating to term-extending options in debt host contracts be applied by analogy to non-debt host contracts that have term extension features? Paragraph 61(g) requires a term-extending option to be considered not clearly and closely related to the debt host contract (as discussed in paragraph 12(a)) if, among other conditions, the interest rate on the debt host is not reset concurrently with the extension to the then current market rate of interest.
No. Paragraph 61(g) is not meant to provide guidance for determining whether term-extending options in non-debt host contracts are clearly and closely related to the host contract, as discussed in paragraph 12(a). Paragraph 61(g) specifically addresses term-extending options in debt hosts, which would typically involve postponement of the repayment of principal. Paragraph 61(g) was designed to prevent circumvention of the guidance in paragraph 61(a), which indicates that an embedded derivative may not be considered clearly and closely related to a debt host if the investor may potentially not recover substantially all of its initial recorded investment. The postponement of repayment of principal does not cause the failure to recover substantially all of its initial recorded investment, though it can significantly reduce the fair value of the recovery of that investment.
A term-extending option in a non-debt host contract can have a significantly different effect than a term-extending option in a debt host contract. Non-debt contracts (as well as debt contracts) that contain embedded term-extension features should be evaluated under paragraph 12 of Statement 133 to determine whether the term-extension feature is a derivative that must be accounted for separately. (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. However, Statement 155 does not apply to hybrid instruments that are not financial instruments. 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.) Paragraph 12 provides that if a host contract contains implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument, the embedded instrument shall be separately accounted for as a derivative if all of the following conditions are met:
- The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract.
- The contract ("the hybrid instrument") that embodies both the embedded derivative instrument and the host contract is not remeasured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur.
- A separate instrument with the same terms as the embedded derivative instrument would, pursuant to paragraphs 6-11, be a derivative instrument subject to the requirements of this Statement. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
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.