FASB Embedded Derivatives Terms of a Separated Non-Option Embedded Derivative When the Holder Has Acquired the Hybrid Instrument Subsequent to Its Inception

FASB: Embedded Derivatives: Terms of a Separated Non-Option Embedded Derivative When the Holder Has Acquired the Hybrid Instrument Subsequent to Its Inception

Derivatives Implementation Group

Statement 133 Implementation Issue No. B23

Title: Embedded Derivatives: Terms of a Separated Non-Option Embedded Derivative When the Holder Has Acquired the Hybrid Instrument Subsequent to Its Inception
Paragraph references: 12
Date cleared by Board: December 6, 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

If the holder has acquired the hybrid instrument that includes a non-option embedded derivative subsequent to the inception of that hybrid instrument, must the terms of that non-option embedded derivative that is separated from the host contract under paragraph 12 be determined by the holder so as to result in the derivative having a fair value of zero (that is, be "at-the-market") at the date the holder enters into (that is, acquires) the hybrid instrument or at the earlier inception of the hybrid instrument when an unrelated third party enters into it?

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. (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 whether an embedded derivative must be assumed to have a fair value of zero (that is, be "at-the-market"). The conclusion in Statement 133 Implementation Issue No. B20, "Must the Terms of a Separated Non-Option Embedded Derivative Produce a Zero Fair Value at Inception?" indicates that in separating a non-option embedded derivative from the host contract under paragraph 12, the terms of that non-option embedded derivative should be determined in a manner that results in a fair value generally equal to zero at the date the holder enters into the hybrid instrument (which is assumed to be the inception of the hybrid instrument). That Issue does not address the bifurcation of the embedded derivative by a holder who has acquired a pre-existing hybrid instrument from a third party subsequent to the inception of that hybrid instrument.

RESPONSE

In separating a non-option embedded derivative from the host contract under paragraph 12 when the holder has acquired the hybrid instrument in a secondary market subsequent to the inception of the hybrid instrument, the terms of the embedded derivative should be determined by the holder so as to result in the derivative having a fair value generally equal to zero at the date the holder enters into (that is, acquires) the hybrid instrument. The initial accounting by the holder of the hybrid instrument should not be impacted by whether it purchased the hybrid instrument at inception or subsequent to inception in a secondary market.

The above guidance should also be applied at the date an entity adopts Statement 133 (if the entity has not elected the grandfathering provisions in paragraph 50) such that the terms of the non-option embedded derivative should be determined by the entity so as to result in the derivative having a fair value generally equal to zero at the date that entity enters into the hybrid instrument regardless whether that date is the inception of the hybrid instrument or a later point in time.

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.