FASB Embedded Derivatives Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option

FASB: Embedded Derivatives: Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option

Derivatives Implementation Group

Statement 133 Implementation Issue No. B38

Title: Embedded Derivatives: Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option
Paragraph references: 9, 12, 13
Date cleared by Board: June 29, 2005
Date posted to website: June 30, 2005

QUESTION

In applying paragraph 12(c) to a put option or call option (including a prepayment option) embedded in a debt instrument, does the potential settlement of the debtor’s obligation to the creditor that would occur upon exercise of the put option or call option meet the net settlement criterion in paragraph 9(a)? The application of paragraph 12(c) is relevant when an embedded put option or call option is not considered to be clearly and closely related to the debt host under paragraph 12(a) and related paragraph 13 or 61(d). Statement 133 Implementation Issue No. B39, "Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor," cleared by the Board concurrent with this Implementation Issue, describes the circumstances in which an embedded call option (including a prepayment option) that can accelerate the settlement of a hybrid instrument containing a debt host contract would not be subject to the conditions in paragraph 13(b).

BACKGROUND

Paragraph 9(a) of Statement 133 states, in part:

   Neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount).

RESPONSE

Yes. The potential settlement of the debtor’s obligation to the creditor that would occur upon exercise of the put option or call option meets the net settlement criterion in paragraph 9(a). The debtor’s settlement of its liability by settling the debt should be considered as not involving the delivery of an asset, notwithstanding whether the creditor concurrently returns to the debtor the evidence of the debtor’s indebtedness (such as a note payable marked "paid" by the creditor). The cash paid to the creditor in settling the debtor’s obligation is not associated with the underlying because cash (paid currently and denominated in the entity’s functional currency), by its very nature, is not related to any underlying for the embedded put option or call option (for example, market interest rates). Therefore, because (1) the debtor does not receive an asset when it settles the debt obligation in conjunction with exercise of the put option or call option and (2) the creditor does not receive an asset associated with the underlying, "neither party is required to deliver an asset that is associated with the underlying…." Thus, the criterion in paragraph 9(a) is met.

The guidance in this Implementation Issue also would be applicable when analyzing the net settlement criterion under paragraph 9(a) for a freestanding call option held by the debtor on its own debt instrument and for a freestanding put option issued by the debtor on its own debt instrument. The guidance in this Implementation Issue does not apply to put or call options that are added to a debt instrument by a third party contemporaneously with or subsequent to the issuance of a debt instrument, guidance for which is provided in Statement 133 Implementation Issue No. B3, "Investor’s Acccounting for a Put or Call Option Attached to a Debt Instrument Contemporaneously with or Subsequent to Its Issuance." The guidance in this issue may not be applied by analogy to an embedded put or call option in a hybrid instrument that does not contain a debt host contract.

If all the criteria in paragraph 12 are met, the embedded put or call option should be bifurcated from the debt host contract and accounted for separately under the provisions of Statement 133.

EFFECTIVE DATE AND TRANSITION

The effective date of the implementation guidance in this Issue is the first day of the first fiscal quarter beginning after December 15, 2005. Earlier application as of the beginning of a fiscal quarter is permitted provided that early application as of the same date is elected for Statement 133 Implementation Issue No. B39, "Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor." If an entity had not bifurcated an embedded derivative but is required to do so under the guidance in this Issue (after also having taken into consideration the guidance in Implementation Issue B39), the entity should account for the effects of initially complying with the implementation guidance prospectively for all existing financial instruments, except for the existing contracts that qualify for the grandfathering provisions of paragraph 50, which exempts certain hybrid instruments from the embedded derivative provisions of Statement 133 on an all-or-none basis. The effects of initially complying with the implementation guidance in this Issue as of the effective date should be reported as a cumulative-effect-type adjustment directly to retained earnings in accordance with FASB Statement No. 154, Accounting Changes and Error Corrections. The cumulative effect adjustment should be calculated in accordance with the transition provisions as described in paragraph 51 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.