FASB Embedded Derivatives Allocating the Basis of a Hybrid Instrument to the Host Contract and the Embedded Derivative

FASB: Embedded Derivatives: Allocating the Basis of a Hybrid Instrument to the Host Contract and the Embedded Derivative

Derivatives Implementation Group

Statement 133 Implementation Issue No. B6

Title: Embedded Derivatives: Allocating the Basis of a Hybrid Instrument to the Host Contract and the Embedded Derivative
Paragraph references: 12-16, 301-303, Footnote 13 (to paragraph 49)
Date cleared by Board: July 28, 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

How should the basis of a hybrid instrument be allocated to the host contract and the embedded derivative when separate accounting for the embedded derivative is required by Statement 133? (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.)

BACKGROUND

Three methods have been identified for determining the initial carrying values of the host contract component and the embedded derivative component of a hybrid instrument:

  1. Estimating the fair value of each individual component of the hybrid instrument and allocating the basis of the hybrid instrument to the host instrument and the embedded derivative based on the proportion of the fair value of each individual component to the overall fair value of the hybrid (a "relative fair value" method).

  2. Recording the embedded derivative at fair value and determining the initial carrying value assigned to the host contract as the difference between the basis of the hybrid instrument and the fair value of the embedded derivative (a "with and without" method based on the fair value of the embedded derivative).

  3. Recording the host contract at fair value and determining the carrying value assigned to the embedded derivative as the difference between the basis of the hybrid instrument and the fair value of the host contract (a "with and without" method based on the fair value of the host contract).

Because the "relative fair value" method (#1 above) involves an independent estimation of the fair value of each component, the sum of the fair values of those components may be greater or less than the initial basis of the hybrid instrument, resulting in an initial carrying amount for the embedded derivative that differs from its fair value. Similarly, the "with and without" method based on the fair value of the host contract (#3 above) may result in an initial carrying amount for the embedded derivative that differs from its fair value. Therefore, both of those methods may result in recognition of an immediate gain or loss upon reporting the embedded derivative at fair value.

RESPONSE

The allocation method that records the embedded derivative at fair value and determines the initial carrying value assigned to the host contract as the difference between the basis of the hybrid instrument and the fair value of the embedded derivative (#2 above) should be used to determine the carrying values of the host contract component and the embedded derivative component of a hybrid instrument when separate accounting for the embedded derivative is required by Statement 133.

Statement 133 requires that an embedded derivative that must be separated from its host contract be measured at fair value. As stated in paragraph 301 of the basis for conclusions, "…the Board believes it should be unusual that an entity would conclude that it cannot reliably separate an embedded derivative from its host contract." Once the carrying value of the host contract is established, it would be accounted for under generally accepted accounting principles applicable to instruments of that type that do not contain embedded derivatives. Upon separation from the host contract, the embedded derivative may be designated as a hedging instrument, if desired, provided it meets the hedge accounting criteria.

If the host contract component of the hybrid instrument is reported at fair value with changes in fair value recognized in earnings or other comprehensive income, then the sum of the fair values of the host contract component and the embedded derivative should not exceed the overall fair value of the hybrid instrument. That is consistent with the requirement of footnote 13 to paragraph 49, which states, in part:

     "For a compound derivative that has a foreign currency exchange risk component (such as a foreign currency interest rate swap), an entity is permitted at the date of initial application to separate the compound derivative into two parts: the foreign currency derivative and the remaining derivative. Each of them would thereafter be accounted for at fair value, with an overall limit that the sum of their fair values could not exceed the fair value of the compound derivative."

While footnote 13 to paragraph 49 addresses separation of a compound derivative upon initial application of Statement 133, the notion that the sum of the fair values of the components should not exceed the overall fair value of the combined instrument is also applicable to hybrid instruments containing a nonderivative host contract and an embedded derivative. However, in instances where the hybrid instrument is reported at fair value with changes in fair value recognized in earnings, paragraph 12(b) would not be met and therefore separation of the embedded derivative from the host contract would not be permitted.

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.