ASC 815-15

Embedded Derivatives

815 Derivatives and Hedging

Download JSON Download Markdown354 paragraphs · 11 sectionsJump to summary

Source downloaded: 2026-09-10T01:36:30.992Z.Record version df979d77a04b. Effective date must be checked in the source.

In brief

AdvancedDerivatives and hedging Financial instruments Fair value Debt and equity

ASC 815-15 governs when a derivative-like feature embedded in a contract that is not itself a derivative in its entirety (a "hybrid instrument") must be separated ("bifurcated") from the host contract and accounted for as a standalone derivative under Subtopic 815-10. Bifurcation is required if and only if all three criteria in 815-15-25-1 are met: the embedded feature's economic characteristics and risks are not clearly and closely related to the host, the hybrid is not already remeasured at fair value through earnings, and a freestanding instrument with the same terms would be a derivative. As an alternative, an entity may irrevocably elect to measure the entire hybrid financial instrument at fair value through earnings (815-15-25-4), and if it cannot reliably identify and measure the embedded derivative it must measure the whole contract at fair value through earnings (815-15-25-53).

Key points (7)

Bifurcation is required if and only if all three criteria in 815-15-25-1 are met: (a) not clearly and closely related, (b) the hybrid is not already remeasured at fair value through earnings, and (c) a separate instrument with the same terms would be a derivative under Section 815-10-15.
An embedded derivative exists only within a single contract; an option added or attached to existing debt by a different counterparty is a freestanding instrument, not an embedded derivative (815-15-25-2; 815-10-15-6).
An entity may irrevocably elect at initial recognition (or at a remeasurement/new basis event) to measure the entire hybrid financial instrument at fair value through earnings, but only after determining that an embedded derivative requiring bifurcation exists (815-15-25-4 through 25-6); such a contract may not be designated as a hedging instrument (815-15-35-1).
Multiple bifurcatable features in one hybrid must be bundled and accounted for as a single compound embedded derivative and may not be split by risk type (815-15-25-7 through 25-9); clearly-and-closely-related features are excluded from the compound derivative (815-15-25-10).
For debt hosts, interest-rate-only embedded features are clearly and closely related unless the investor could fail to recover substantially all of its initial recorded investment or the feature could at least double the investor's initial rate of return and produce twice the then-current market return (815-15-25-26); commodity-, equity-, and third-party-credit-indexed features are not clearly and closely related (815-15-25-47 through 25-49, 25-51), while creditworthiness of the obligor and nonleveraged inflation indexing are (815-15-25-46, 25-50).
Call/put options that accelerate settlement of debt are tested under the four-step decision sequence in 815-15-25-42 (index adjustment, underlying other than interest rate or credit risk, substantial premium or discount, contingently exercisable acceleration of principal).
On separation, the embedded derivative is recorded at fair value and the host is assigned the residual carrying amount (815-15-30-2); non-option embedded derivatives are calibrated to a fair value of zero at inception (815-15-30-4), but option-based embedded derivatives use the stated strike and are not adjusted to be at the money (815-15-30-6).

For students. Bifurcation analysis is a staple of structured finance and convertible debt questions: memorize the three-part test in 815-15-25-1 and the debt-host "clearly and closely related" examples. The most common mistake is skipping criterion (c) — many features (e.g., conversion options on the issuer's own stock, equity kickers indexed to non-readily-convertible assets) fail bifurcation because a freestanding instrument with the same terms would not be a derivative at all.

embedded derivative hybrid instrument host contract clearly and closely related bifurcation fair value election compound embedded derivative debt versus equity host

Machine-generated study aid for ASC 815-15. Check the source paragraphs below.

815-15-00Status

Source downloaded: 2026-09-10T01:35:56.033Z.Record version 6c11f6117aba. Effective date must be checked in the source.

815-15-00-1

The following table identifies the changes made to this Subtopic.

Paragraph	Action	Accounting Standards Update	Date

Benchmark Interest Rate	Added	Accounting Standards Update No. 2017-12	08/28/2017
Commencement Date of the Lease (Commencement Date)	Added	Accounting Standards Update No. 2016-02	02/25/2016
Contract	Added	Accounting Standards Update No. 2016-02	02/25/2016
Credit Risk	Amended	Accounting Standards Update No. 2017-12	08/28/2017
Credit Risk	Amended	Accounting Standards Update No. 2010-08	02/02/2010
Embedded Credit Derivative	Added	Accounting Standards Update No. 2010-11	03/05/2010
Financial Instrument	Amended	Accounting Standards Update No. 2024-02	03/29/2024
Financial Liability	Added	Accounting Standards Update No. 2018-03	02/28/2018
Interest Rate Risk	Amended	Accounting Standards Update No. 2017-12	08/28/2017
Lease	Added	Accounting Standards Update No. 2016-02	02/25/2016
Lessee	Added	Accounting Standards Update No. 2016-02	02/25/2016
Lessor	Added	Accounting Standards Update No. 2016-02	02/25/2016
Market Risk Benefit	Added	Accounting Standards Update No. 2018-12	08/15/2018
Other Comprehensive Income	Added	Maintenance Update 2014-20 (PDF)	09/29/2014
Payout Phase	Added	Accounting Standards Update No. 2014-06	03/14/2014
Public Business Entity	Amended	Maintenance Update 2017-06 (PDF)	04/07/2017
Public Business Entity	Amended	Maintenance Update 2016-11 (PDF)	06/27/2016
Public Business Entity	Added	Accounting Standards Update No. 2014-16	11/03/2014
Readily Convertible to Cash	Amended	Accounting Standards Update No. 2024-02	03/29/2024
Remeasurement Event	Amended	Accounting Standards Update No. 2016-13	06/16/2016
Transaction	Amended	Accounting Standards Update No. 2024-02	03/29/2024
Underlying Asset	Added	Accounting Standards Update No. 2016-02	02/25/2016
Variable Lease Payments	Added	Accounting Standards Update No. 2016-02	02/25/2016

815-15-15-6	Amended	Accounting Standards Update No. 2016-01	01/05/2016
815-15-15-8	Superseded	Accounting Standards Update No. 2010-11	03/05/2010
815-15-15-9	Amended	Accounting Standards Update No. 2010-11	03/05/2010
815-15-25-1	Amended	Accounting Standards Update No. 2018-09	07/16/2018
815-15-25-4	Amended	Accounting Standards Update No. 2018-03	02/28/2018
815-15-25-5	Amended	Accounting Standards Update No. 2016-13	06/16/2016
815-15-25-5	Amended	Accounting Standards Update No. 2016-01	01/05/2016
815-15-25-14	Amended	Accounting Standards Update No. 2020-06	08/05/2020
815-15-25-15	Amended	Accounting Standards Update No. 2020-06	08/05/2020
815-15-25-16	Amended	Accounting Standards Update No. 2014-16	11/03/2014
815-15-25-16	Amended	Accounting Standards Update No. 2010-11	03/05/2010
815-15-25-17	Amended	Accounting Standards Update No. 2014-16	11/03/2014
815-15-25-17A through 25-17D	Added	Accounting Standards Update No. 2014-16	11/03/2014
815-15-25-18	Amended	Accounting Standards Update No. 2010-11	03/05/2010
815-15-25-20	Amended	Accounting Standards Update No. 2014-16	11/03/2014
815-15-25-22	Amended	Accounting Standards Update No. 2016-02	02/25/2016
815-15-25-26	Amended	Accounting Standards Update No. 2010-08	02/02/2010
815-15-25-37	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-25-40 through 25-42	Amended	Accounting Standards Update No. 2010-08	02/02/2010
815-15-25-40	Superseded	Accounting Standards Update No. 2016-06	03/14/2016
815-15-25-41	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-25-42	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-25-51A	Added	Accounting Standards Update No. 2010-11	03/05/2010
815-15-30-3	Amended	Accounting Standards Update No. 2012-04	10/01/2012
815-15-35-3	Amended	Maintenance Update 2014-20 (PDF)	09/29/2014
815-15-45-2	Added	Accounting Standards Update No. 2018-03	02/28/2018
815-15-50-2	Amended	Accounting Standards Update No. 2025-11	12/08/2025
815-15-55-4	Amended	Accounting Standards Update No. 2016-02	02/25/2016
815-15-55-7	Amended	Accounting Standards Update No. 2016-02	02/25/2016
815-15-55-8	Amended	Accounting Standards Update No. 2012-04	10/01/2012
815-15-55-13	Amended	Accounting Standards Update No. 2010-08	02/02/2010
815-15-55-18	Amended	Accounting Standards Update No. 2012-04	10/01/2012
815-15-55-35	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-55-37	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-55-39	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-55-43	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-55-45	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-55-47	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-55-54	Amended	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-55	Amended	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-55	Amended	Accounting Standards Update No. 2012-04	10/01/2012
815-15-55-57	Superseded	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-57	Amended	Accounting Standards Update No. 2014-06	03/14/2014
815-15-55-58	Amended	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-59 through 55-61	Superseded	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-62	Amended	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-67	Amended	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-69	Amended	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-74	Amended	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-75	Amended	Accounting Standards Update No. 2018-12	08/15/2018
815-15-55-76A	Amended	Accounting Standards Update No. 2020-06	08/05/2020
815-15-55-76B	Added	Accounting Standards Update No. 2020-06	08/05/2020
815-15-55-99	Amended	Accounting Standards Update No. 2012-04	10/01/2012
815-15-55-124	Amended	Accounting Standards Update No. 2016-06	03/14/2016
815-15-55-165	Amended	Accounting Standards Update No. 2010-11	03/05/2010
815-15-55-166	Amended	Accounting Standards Update No. 2010-11	03/05/2010
815-15-55-169	Amended	Accounting Standards Update No. 2010-11	03/05/2010
815-15-55-210	Amended	Maintenance Update 2020-18 (PDF)	11/25/2020
815-15-55-212	Amended	Accounting Standards Update No. 2010-08	02/02/2010
815-15-55-216	Amended	Accounting Standards Update No. 2016-19	12/14/2016
815-15-55-218	Amended	Accounting Standards Update No. 2020-06	08/05/2020
815-15-55-219	Amended	Accounting Standards Update No. 2020-06	08/05/2020
815-15-55-224 through 55-226	Amended	Accounting Standards Update No. 2010-11	03/05/2010
815-15-55-226A through 55-226D	Added	Accounting Standards Update No. 2010-11	03/05/2010
815-15-65-1	Added	Accounting Standards Update No. 2010-08	02/02/2010
815-15-65-2	Added	Accounting Standards Update No. 2014-16	11/03/2014
815-15-65-3	Added	Accounting Standards Update No. 2016-06	03/14/2016

815-15-05Overview and Background

Source downloaded: 2026-09-10T01:35:59.276Z.Record version 9ddbc2e219fa. Effective date must be checked in the source.

815-15-05-1

Contracts that do not in their entirety meet the definition of a derivative instrument (see paragraphs

815-10-15-83 through 15-139

), such as bonds, insurance policies, and leases, may contain embedded derivatives. The effect of embedding a derivative instrument in another type of contract (the host contract) is that some or all of the cash flows or other exchanges that otherwise would be required by the host contract, whether unconditional or contingent on the occurrence of a specified event, will be modified based on one or more underlyings.

815-15-15Scope and Scope Exceptions

Source downloaded: 2026-09-10T01:36:03.191Z.Record version bdd0d3a84db7. Effective date must be checked in the source.

Entities

815-15-15-1

The guidance in this Subtopic applies to all entities.

Instruments

815-15-15-2

The guidance in this Subtopic applies only to contracts that do not meet the definition of a derivative instrument in their entirety.

815-15-15-3

The guidance in this Subtopic does not apply to any of the following items, as discussed further in this Section:

a
Normal purchases and normal sales contracts
b
Unsettled foreign currency transactions
c
Plain-vanilla servicing rights
d
Features involving certain aspects of credit risk
e
Features involving certain currencies.

815-15-15-4

A contract that meets the definition of a derivative instrument in its entirety but qualifies for the normal purchases and normal sales scope exception as discussed beginning in paragraph 815-10-15-22 shall not also be assessed under paragraph 815-15-25-1.

815-15-15-5

Unsettled foreign currency transactions, including financial instruments, shall not be considered to contain embedded foreign currency derivatives under this Subtopic if the transactions meet all of the following criteria:

a
They are monetary items.
b
They have their principal payments, interest payments, or both denominated in a foreign currency.
c
They are subject to the requirement in Subtopic 830-20 to recognize any foreign currency transaction gain or loss in earnings.

815-15-15-6

The proscription in paragraph 815-15-15-5 applies to available-for-sale or trading debt securities that have cash flows denominated in a foreign currency.

815-15-15-7

Plain-vanilla servicing rights, which involve an obligation to perform servicing and the right to receive fees for performing that servicing, do not contain an embedded derivative that would be separated from those servicing rights and accounted for as a derivative instrument.

815-15-15-8

Paragraph superseded by Accounting Standards Update No. 2010-11.

815-15-15-9

The transfer of credit risk that is only in the form of subordination of one financial instrument to another (such as the subordination of one beneficial interest to another tranche of a securitization, thereby redistributing credit risk) is an embedded derivative feature that shall not be subject to the application of paragraph 815-10-15-11 and Section 815-15-25. Only the embedded credit derivative feature created by subordination between the financial instruments is not subject to the application of paragraph 815-10-15-11 and Section 815-15-25. However, other embedded credit derivative features (for example, those related to credit default swaps on a referenced credit) would be subject to the application of paragraph 815-10-15-11 and Section 815-15-25 even if their effects are allocated to interests in tranches of securitized financial instruments in accordance with those subordination provisions. Consequently, the following circumstances (among others) would not qualify for the scope exception and are subject to the application of paragraph 815-10-15-11 and Section 815-15-25 for potential bifurcation:

a
An embedded derivative feature relating to another type of risk (including another type of credit risk) is present in the securitized financial instruments.
b
The holder of an interest in a tranche of that securitized financial instrument is exposed to the possibility (however remote) of being required to make potential future payments (not merely receive reduced cash inflows) because the possibility of those future payments is not created by subordination. (Note, however, that the securitized financial instrument may involve other tranches that are not exposed to potential future payments and, thus, those other tranches might qualify for the scope exception.)
c
The holder owns an interest in a single-tranche securitization vehicle; therefore, the subordination of one tranche to another is not relevant.

815-15-15-10

An embedded foreign currency derivative shall not be separated from the host contract and considered a derivative instrument under paragraph 815-15-25-1 if all of the following criteria are met:

a
The host contract is not a financial instrument.
b
The host contract requires payment(s) denominated in any of the following currencies:
1. 1
  The functional currency of any substantial party to that contract
2. 2
  The currency in which the price of the related good or service that is acquired or delivered is routinely denominated in international commerce (for example, the U.S. dollar for crude oil transactions)
3. 3
  The local currency of any substantial party to the contract
4. 4
  The currency used by a substantial party to the contract as if it were the functional currency because the primary economic environment in which the party operates is highly inflationary (as discussed in paragraph 830-10-45-11).
c
Other aspects of the embedded foreign currency derivative are clearly and closely related to the host contract.

The evaluation of whether a contract qualifies for the scope exception in this paragraph shall be performed only at inception of the contract.

815-15-15-11

The decision about the currency of the primary economic environment in which a counterparty to a contract operates can be based on available information and reasonable assumptions about the counterparty; representations from the counterparty are not required.

815-15-15-12

When determining who is a substantial party to the contract for purposes of applying paragraph 815-15-15-10(b)(1), the entity shall do both of the following:

a
Consider all facts and circumstances pertaining to that contract (including whether the contracting party possesses the requisite knowledge, resources, and technology to fulfill the contract without relying on related parties)
b
Look through the legal form to evaluate the substance of the underlying relationships.

815-15-15-13

Example 1 (see paragraph 815-15-55-83) illustrates the application of this guidance.

815-15-15-14

The application of the phrase routinely denominated in international commerce in paragraph 815-15-15-10(b)(2) shall be based on how similar transactions for a certain product or service are routinely structured around the world, not just in one local area. If similar transactions for a certain product or service are routinely denominated in international commerce in various different currencies, the scope exception in that paragraph shall not apply to any of those similar transactions.

815-15-15-15

The guidance in paragraph 815-15-15-10 relating to embedded foreign currency derivatives within nonfinancial contracts relates to all embedded foreign currency caps or floors within such contracts. That guidance does not relate to all embedded foreign currency options within such contracts (such as an embedded foreign currency option that merely introduces a cap or floor on the functional currency equivalent price under a purchase contract). The embedded foreign currency cap or floor (or combination thereof) within a nonfinancial contract shall be considered clearly and closely related to the host nonfinancial contract, and thus not be accounted for separately as a derivative instrument, only if all of the following criteria are met:

a
The nonfinancial contract requires payment(s) denominated in any of the currencies permitted by paragraphs 815-15-15-10(b).
b
The embedded cap or floor (or combination thereof) does not contain leverage features.
c
The embedded cap or floor (or combination thereof) does not represent a written or net written option.

815-15-15-16

When an embedded cap or floor (or combination thereof) represents a purchased or net purchased option to one party to the contract, it represents a written or net written option to the counterparty to that contract. In that circumstance, that counterparty does not qualify for the paragraph 815-15-15-10 exclusion because the criterion in (c) in the preceding paragraph would not be met (due to the embedded foreign currency cap or floor [or combination thereof] representing a written or net written option).

815-15-15-17

If the embedded derivative represented a zero-cost collar (as described beginning in paragraph 815-20-25-88), both parties to the contract would meet the criterion in paragraph 815-15-15-15(c) and be eligible to qualify for the exclusion in paragraph 815-15-15-10.

815-15-15-18

If a financial or nonfinancial contract contained an option that allowed the payer to remit funds in an equivalent amount of a currency other than the functional currency of a substantial party to the contract at the payment date, that option shall not be separated from the host contract because the option merely allows the payer to make an equivalent payment in a choice of currencies (based on current spot prices).

815-15-15-19

The guidance in paragraphs

815-15-15-15 through 15-18

is not meant to address every possible type of foreign currency option that may be embedded in a nonfinancial contract, and an analogy to that guidance may not be appropriate for such foreign currency options.

815-15-15-20

Although the scope exception in paragraph 815-15-15-10 does not apply to financial instruments, that paragraph applies if a normal insurance contract involves payment in the functional currency of either of the two parties to the contract.

815-15-15-21

Paragraph 815-15-15-10 applies also to a normal insurance contract if it involves payment in the local currency of the country in which the loss is incurred, irrespective of the functional currencies of the parties to the transaction.

815-15-25Recognition

Source downloaded: 2026-09-10T01:36:08.184Z.Record version 9a370e03408b. Effective date must be checked in the source.

815-15-25-1

An embedded derivative shall be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the following criteria are met:

a
The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
b
The hybrid instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported in earnings as they occur.
c
A separate instrument with the same terms as the embedded derivative would, pursuant to Section 815-10-15, be a derivative instrument subject to the requirements of Subtopic 815-10 and this Subtopic. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

815-15-25-2

The notion of an embedded derivative in a hybrid instrument refers to provisions incorporated into a single contract, and not to provisions in separate contracts between different counterparties. Paragraph 815-10-15-6 states that an option that is added or attached to an existing debt instrument by another party results in the investor having different counterparties for the option and the debt instrument and, thus, the option shall not be considered an embedded derivative.

815-15-25-3

The remainder of the guidance in this Section is organized as follows:

a
Fair value election for hybrid financial instruments
b
Compound embedded derivative
c
Interests in securitized financial assets—holder's accounting
d
Applying the separate instrument criterion
e
Applying the clearly and closely related criterion
f
Entity unable to reliably identify and measure embedded derivative
g
Host contract after separation.

Fair Value Election for Hybrid Financial Instruments

815-15-25-4

An entity that initially recognizes a hybrid financial instrument that under paragraph 815-15-25-1 would be required to be separated into a host contract and a derivative instrument may irrevocably elect to initially and subsequently measure that hybrid financial instrument in its entirety at fair value (with changes in fair value recognized in earnings and, if paragraph 825-10-45-5 is applicable, other comprehensive income). A financial instrument shall be evaluated to determine that it has an embedded derivative requiring bifurcation before the instrument can become a candidate for the fair value election.

815-15-25-5

The fair value election shall be supported by concurrent documentation or a preexisting documented policy for automatic election. That recognized hybrid financial instrument could be an asset or a liability and it could be acquired or issued by the entity. The fair value election is also available when a previously recognized financial instrument is subject to a remeasurement event (new basis event) and the separate recognition of an embedded derivative. The fair value election may be made instrument by instrument. For purposes of this paragraph, a remeasurement event (new basis event) is an event identified in generally accepted accounting principles, other than the recording of a credit loss under Topic 326, or measurement of an impairment loss through earnings under Topic 321 on equity investments, that requires a financial instrument to be remeasured to its fair value at the time of the event but does not require that instrument to be reported at fair value on a continuous basis with the change in fair value recognized in earnings. Examples of remeasurement events are business combinations and significant modifications of debt as defined in Subtopic 470-50.

815-15-25-6

The fair value election shall not be applied to the hybrid instruments described in paragraph 825-10-50-8.

Compound Embedded Derivative

815-15-25-7

If a hybrid instrument contains more than one embedded derivative feature that would individually warrant separate accounting as a derivative instrument under paragraph 815-15-25-1, those embedded derivative features shall be bundled together as a single, compound embedded derivative that shall then be bifurcated and accounted for separately from the host contract under this Subtopic unless a fair value election is made pursuant to paragraph 815-15-25-4.

815-15-25-8

An entity shall not separate a compound embedded derivative into components representing different risks (for example, based on the risks discussed in paragraphs 815-20-25-12[f] and 815-20-25-15[i]) and then account for those components separately.

815-15-25-9

If a compound embedded derivative comprises 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 shall not separate that compound embedded derivative into components that would be accounted for separately.

815-15-25-10

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 shall not be included in the compound embedded derivative that is bifurcated from the host contract and separately accounted for.

Interests in Securitized Financial Assets—Holder's Accounting

815-15-25-11

Paragraph 815-10-15-11 explains that the holder of an interest in securitized financial assets (other than those identified in paragraphs

815-10-15-72 through 15-73

) shall determine whether the interest is a freestanding derivative instrument or contains an embedded derivative that under this Section would be required to be separated from the host contract and accounted for separately.

815-15-25-12

That determination shall be based on an analysis of the contractual terms of the interest in securitized financial assets, which requires understanding the nature and amount of assets, liabilities, and other financial instruments that compose the entire securitization transaction.

815-15-25-13

A holder of an interest in securitized financial assets shall obtain sufficient information about the payoff structure and the payment priority of the interest to determine whether an embedded derivative exists.

Applying the Separate Instrument Criterion

815-15-25-14

The criterion in paragraph 815-15-25-1(c) is not met if the separate instrument with the same terms as the embedded derivative would be classified as a liability (or an asset in some circumstances) under the provisions of Topic 480 but would be classified in stockholders' equity absent the provisions in that Topic. For purposes of analyzing the application of paragraph 815-10-15-74(a) to an embedded derivative as though it were a separate instrument, paragraphs

480-10-25-4 through 25-14

shall be disregarded. Those embedded features are analyzed by applying other applicable guidance (such as the guidance in Subtopic 815-40 on contracts in entity's own equity).

815-15-25-15

Paragraph 815-40-25-39 states that, for purposes of evaluating under paragraph 815-15-25-1 whether an embedded derivative indexed to an entity's own stock would be classified in stockholders' equity if freestanding, the additional considerations necessary for equity classification beginning in paragraph 815-40-25-7 do not apply if the hybrid contract is a convertible debt instrument (see paragraph 815-40-25-41) in which the holder may only realize the value of the conversion option by exercising the option and receiving the entire proceeds in a fixed number of shares or the equivalent amount of cash (at the discretion of the issuer). However, paragraph 815-40-25-40 states that those additional considerations do apply when an issuer is evaluating whether any embedded derivative other than those discussed in paragraph 815-40-25-39 is an equity instrument and thereby excluded from the scope of this Subtopic.

815-15-25-16

If the host contract encompasses a residual interest in an entity, then its economic characteristics and risks shall be considered that of an equity instrument and an embedded derivative would need to possess principally equity characteristics (related to the same entity) to be considered clearly and closely related to the host contract.

815-15-25-17

Because the changes in fair value of an equity interest and interest rates on a debt instrument are not clearly and closely related, the terms of convertible preferred stock shall be analyzed to determine whether the preferred stock (and thus the potential host contract) is more akin to an equity instrument or a debt instrument.

815-15-25-17A

For a hybrid financial instrument issued in the form of a share, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, weighing each term and feature on the basis of the relevant facts and circumstances. That is, in determining the nature of the host contract, an entity shall consider the economic characteristics and risks of the entire hybrid financial instrument including the embedded derivative feature that is being evaluated for potential bifurcation. In evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature does not necessarily determine the economic characteristics and risks of the host contract. Although an individual term or feature may weigh more heavily in the evaluation on the basis of the facts and circumstances, an entity should use judgment based on an evaluation of all of the relevant terms and features. For example, an entity shall not presume that the presence of a fixed-price, noncontingent redemption option held by the investor in a convertible preferred stock contract, in and of itself, determines whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument. Rather, the nature of the host contract depends on the economic characteristics and risks of the entire hybrid financial instrument.

815-15-25-17B

The guidance in paragraph 815-15-25-17A relates to determining whether a host contract within a hybrid financial instrument issued in the form of a share is considered to be more akin to a debt instrument or more akin to an equity instrument for the purposes of evaluating one or more embedded derivative features for bifurcation under paragraph 815-15-25-1(a). It is not intended to address when an embedded derivative feature should be bifurcated from the host contract or the accounting when such bifurcation is required. In addition, the guidance in paragraph 815-15-25-17A is not intended to prescribe the method to be used in determining the nature of the host contract in a hybrid financial instrument that is not issued in the form of a share.

815-15-25-17C

When applying the guidance in paragraph 815-15-25-17A, an entity shall determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, determining whether those terms and features are debt-like versus equity-like, and weighing those terms and features on the basis of the relevant facts and circumstances. That is, an entity shall consider not only whether the relevant terms and features are debt-like versus equity-like, but also the substance of those terms and features (that is, the relative strength of the debt-like or equity-like terms and features given the facts and circumstances). In assessing the substance of the relevant terms and features, each of the following may form part of the overall analysis and may inform an entity's overall consideration of the relative importance (and, therefore, weight) of each term and feature among other terms and features:

a
The characteristics of the relevant terms and features themselves (for example, contingent versus noncontingent, in-the-money versus out-of-the-money)
b
The circumstances under which the hybrid financial instrument was issued or acquired (for example, issuer-specific characteristics, such as whether the issuer is thinly capitalized or profitable and well-capitalized)
c
The potential outcomes of the hybrid financial instrument (for example, the instrument may be settled by the issuer issuing a fixed number of shares, the instrument may be settled by the issuer transferring a specified amount of cash, or the instrument may remain legal-form equity), as well as the likelihood of those potential outcomes. The assessment of the potential outcomes may be qualitative in nature.

815-15-25-17D

The following are examples (and not an exhaustive list) of common terms and features included within a hybrid financial instrument issued in the form of a share and the types of information and indicators that an entity (an issuer or an investor) may consider when assessing the substance of those terms and features in the context of determining the nature of the host contract, as discussed in paragraph 815-15-25-17C:

a
Redemption rights. The ability for an issuer or investor to redeem a hybrid financial instrument issued in the form of a share at a fixed or determinable price generally is viewed as a debt-like characteristic. However, not all redemption rights are of equal importance. For example, a noncontingent redemption option may be given more weight in the analysis than a contingent redemption option. The relative importance (and, therefore, weight) of redemption rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. 1
  Whether the redemption right is held by the issuer or investors
2. 2
  Whether the redemption is mandatory
3. 3
  Whether the redemption right is noncontingent or contingent
4. 4
  Whether (and the degree to which) the redemption right is in-the-money or out-of-the-money
5. 5
  Whether there are any laws that would restrict the issuer or investors from exercising the redemption right (for example, if redemption would make the issuer insolvent)
6. 6
  Issuer-specific considerations (for example, whether the hybrid financial instrument is effectively the residual interest in the issuer [due to the issuer being thinly capitalized or the common equity of the issuer having already incurred losses] or whether the instrument was issued by a well-capitalized, profitable entity)
7. 7
  If the hybrid financial instrument also contains a conversion right, the extent to which the redemption price (formula) is more or less favorable than the conversion price (formula), that is, a consideration of the economics of the redemption price (formula) and the conversion price (formula), not simply the form of the settlement upon redemption or conversion.
b
Conversion rights. The ability for an investor to convert, for example, a preferred share into a fixed number of common shares generally is viewed as an equity-like characteristic. However, not all conversion rights are of equal importance. For example, a conversion option that is noncontingent or deeply in-the-money may be given more weight in the analysis than a conversion option that is contingent on a remote event or deeply out-of-the-money. The relative importance (and, therefore, weight) of conversion rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. 1
  Whether the conversion right is held by the issuer or investors
2. 2
  Whether the conversion is mandatory
3. 3
  Whether the conversion right is noncontingent or contingent
4. 4
  Whether (and the degree to which) the conversion right is in-the-money or out-of-the-money
5. 5
  If the hybrid financial instrument also contains a redemption right held by the investors, whether conversion is more likely to occur before redemption (for example, because of an expected initial public offering or change-in-control event before the redemption right becoming exercisable).
c
Voting rights. The ability for a class of stock to exercise voting rights generally is viewed as an equity-like characteristic. However, not all voting rights are of equal importance. For example, voting rights that allow a class of stock to vote on all significant matters may be given more weight in the analysis than voting rights that are only protective in nature. The relative importance (and, therefore, weight) of voting rights among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. 1
  On which matters the voting rights allow the investor's class of stock to vote (relative to common stock shareholders)
2. 2
  How much influence the investor's class of stock can exercise as a result of the voting rights.
d
Dividend rights. The nature of dividends can be viewed as a debt-like or equity-like characteristic. For example, mandatory fixed dividends generally are viewed as a debt-like characteristic, while discretionary dividends based on earnings generally are viewed as an equity-like characteristic. The relative importance (and, therefore, weight) of dividend terms among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. 1
  Whether the dividends are mandatory or discretionary
2. 2
  The basis on which dividends are determined and whether the dividends are stated or participating
3. 3
  Whether the dividends are cumulative or noncumulative.
e
Protective covenants. Protective covenants generally are viewed as a debt-like characteristic. However, not all protective covenants are of equal importance. Covenants that provide substantive protective rights may be given more weight than covenants that provide only limited protective rights. The relative importance (and, therefore, weight) of protective covenants among other terms and features in a hybrid financial instrument may be evaluated on the basis of information about the following (among other relevant) facts and circumstances:
1. 1
  Whether there are any collateral requirements akin to collateralized debt
2. 2
  If the hybrid financial instrument contains a redemption option held by the investor, whether the issuer's performance upon redemption is guaranteed by the parent of the issuer
3. 3
  Whether the instrument provides the investor with certain rights akin to creditor rights (for example, the right to force bankruptcy or a preference in liquidation).

815-15-25-18

The following guidance is relevant in deciding whether the economic characteristics and risks of the embedded derivative are clearly and closely related to the economic characteristics and risks of the host contract. The guidance is organized as follows:

a
Purchase contracts—price cap and price floor
b
Host contracts with equity characteristics
c
Host contracts that are leases
d
Host contracts with debt characteristics
e
Hybrid instruments that are beneficial interests in securitized financial assets.

815-15-25-19

The economic characteristics and risks of a floor and cap on the price of an asset embedded in a contract to purchase that asset are clearly and closely related to the purchase contract, because the options are indexed to the purchase price of the asset that is the subject of the purchase contract. See Example 6 (paragraph 815-15-55-114) for an illustration of such options.

815-15-25-20

A put option that enables the holder to require the issuer of an equity instrument (which has been deemed to contain an equity host contract in accordance with paragraphs

815-15-25-17A through 25-17D

) to reacquire that equity instrument for cash or other assets is not clearly and closely related to that equity instrument. Thus, such a put option embedded in a publicly traded equity instrument to which it relates shall be separated from the host contract by the holder of the equity instrument if the criteria in paragraph 815-15-25-1(b) through (c) are also met. That put option also shall be separated from the host contract by the issuer of the equity instrument except in those circumstances in which the put option is not considered to be a derivative instrument pursuant to paragraph 815-10-15-74(a) because it is classified in stockholders' equity. A purchased call option that enables the issuer of an equity instrument (such as common stock) to reacquire that equity instrument would not be considered to be a derivative instrument by the issuer of the equity instrument pursuant to that paragraph. Thus, if the call option were embedded in the related equity instrument, it would not be separated from the host contract by the issuer. However, for the holder of the related equity instrument, the embedded written call option would not be considered to be clearly and closely related to the equity instrument, if the criteria in paragraph 815-15-25-1(b) through (c) were met, and shall be separated from the host contract.

815-15-25-21

Rentals for the use of leased assets and adjustments for inflation on similar property are considered to be clearly and closely related. Thus, unless a significant leverage factor is involved, the inflation-related derivative instrument embedded in an inflation-indexed lease would not be separated from the host contract.

815-15-25-22

The obligation to make future payments for the use of leased assets and the adjustment of those payments to reflect changes in a variable-interest-rate index are considered to be clearly and closely related. Thus, leases that include variable lease payments based on changes in the prime rate would not have the embedded derivative that is related to the variable lease payment separated from the host contract.

815-15-25-23

This guidance is organized as follows:

a
Characteristics of a debt host contract
b
Interest-rate-related underlyings
c
Call options and put options on debt instruments
d
Term-extending options
e
Credit-sensitive payments
f
Commodity-indexed interest or principal payments
g
Equity-indexed interest payments
h
Inflation-indexed principal payments
i
Convertible debt.

815-15-25-24

The characteristics of a debt host contract generally shall be based on the stated or implied substantive terms of the hybrid instrument. Those terms may include a fixed-rate, variable-rate, zero-coupon, discount or premium, or some combination thereof.

815-15-25-25

In the absence of stated or implied terms, an entity may make its own determination of whether to account for the debt host as a fixed-rate, variable-rate, or zero-coupon bond. That determination requires the application of judgment, which is appropriate because the circumstances surrounding each hybrid instrument containing an embedded derivative may be different. That is, in the absence of stated or implied terms, it is appropriate to consider the features of the hybrid instrument, the issuer, and the market in which the instrument is issued, as well as other factors, to determine the characteristics of the debt host contract. However, an entity shall not express the characteristics of the debt host contract in a manner that would result in identifying an embedded derivative that is not already clearly present in a hybrid instrument. For example, it would be inappropriate to do either of the following:

a
Identify a variable-rate debt host contract and an interest rate swap component that has a comparable variable-rate leg in an embedded compound derivative, in lieu of identifying a fixed-rate debt host contract
b
Identify a fixed-rate debt host contract and a fixed-to-variable interest rate swap component in an embedded compound derivative in lieu of identifying a variable-rate debt host contract.

815-15-25-26

For purposes of applying the provisions of paragraph 815-15-25-1, an embedded derivative in which the only underlying is an interest rate or interest rate index (such as an interest rate cap or an interest rate collar) that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract that is considered a debt instrument is considered to be clearly and closely related to the host contract unless either of the following conditions exists:

a
The hybrid instrument can contractually be settled in such a way that the investor (the holder or the creditor) would not recover substantially all of its initial recorded investment (that is, the embedded derivative contains a provision that permits any possibility whatsoever that the investor's [the holder's or the creditor's] undiscounted net cash inflows over the life of the instrument would not recover substantially all of its initial recorded investment in the hybrid instrument under its contractual terms).
b
The embedded derivative meets both of the following conditions:
1. 1
  There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor's initial rate of return on the host contract (that is, the embedded derivative contains a provision that could under any possibility whatsoever at least double the investor's initial rate of return on the host contract).
2. 2
  For any of the possible interest rate scenarios under which the investor's initial rate of return on the host contract would be doubled (as discussed in (b)(1)), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under the relevant future interest rate scenario) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer's credit quality at inception.

815-15-25-27

Even though the conditions in (a) and (b) in the preceding paragraph focus on the investor's rate of return and the investor's recovery of its investment, the existence of either of those conditions would result in the embedded derivative not being considered clearly and closely related to the host contract by both parties to the hybrid instrument. Because the existence of those conditions is assessed at the date that the hybrid instrument is acquired (or incurred) by the reporting entity, the acquirer of a hybrid instrument in the secondary market could potentially reach a different conclusion than could the issuer of the hybrid instrument due to applying the conditions in the preceding paragraph at different points in time.

815-15-25-28

An embedded derivative that alters net interest payments based on changes in a stock price index (or another non-interest-rate index) is not addressed in paragraph 815-15-25-26.

815-15-25-29

The condition in paragraph 815-15-25-26(a) applies only to those situations in which the investor (creditor) could be forced by the terms of a hybrid instrument to accept settlement at an amount that causes the investor not to recover substantially all of its initial recorded investment. That condition does not apply to a situation in which the terms of a hybrid instrument permit, but do not require, the investor to settle the hybrid instrument in a manner that causes it not to recover substantially all of its initial recorded investment, provided that the issuer does not have the contractual right to demand a settlement that causes the investor not to recover substantially all of its initial net investment.

815-15-25-30

Paragraphs

815-10-15-72 through 15-73

address the scope application of this Subtopic to interest-only strips and principal-only strips.

815-15-25-31

The remainder of this guidance on interest-rate-related underlyings is organized as follows:

a
Interest rate floors, caps, and collars
b
Exception for certain securitized interest in prepayable financial assets
c
Exception for call options exercisable only by the debtor.

815-15-25-32

Floors or caps (or collars, which are combinations of caps and floors) on interest rates and the interest rate on a debt instrument are considered to be clearly and closely related unless the conditions in either paragraph 815-15-25-26(a) or 815-15-25-26(b) are met, in which circumstance the floors or the caps are not considered to be clearly and closely related.

815-15-25-33

A securitized interest in prepayable financial assets would not be subject to the conditions in paragraph 815-15-25-26(b) if it meets both of the following criteria:

a
The right to accelerate the settlement of the securitized interest cannot be controlled by the investor.
b
The securitized interest itself does not contain an embedded derivative (including an interest-rate-related derivative instrument) for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets.

815-15-25-34

This exception from paragraph 815-15-25-26(b) is limited to securitized interests that contain only an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets and that meet the criteria in the preceding paragraph. If a securitized interest contains any other 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 and those terms create an embedded derivative that requires bifurcation (ignoring the effects of the embedded call options in the underlying financial assets), that securitized interest would be subject to the requirements of paragraph 815-15-25-26(b) (for example, an inverse floater).

815-15-25-35

Whether the securitized interest itself contains an embedded derivative (including an interest-rate-related derivative instrument) for which bifurcation would be required, other than an embedded derivative that results solely from the embedded call options in the underlying financial assets, shall be determined in accordance with paragraphs

815-15-25-11 through 25-13

. This assessment is expected to be simple for basic securitized interests but could be more difficult for complex securitized interests (for example, in securitizations involving the resecuritization of tranches from previous transactions, the analysis might require an understanding of each securitization making up the resecuritization transaction).

815-15-25-36

A securitized interest in prepayable financial assets that does not meet both of the criteria in paragraph 815-15-25-33 is subject to the conditions in paragraph 815-15-25-26(b). When assessing the conditions in paragraph 815-15-25-26(b) for those instruments, an entity shall consider the effect of prepayment risk. Example 11 (see paragraph 815-15-55-137) illustrates the application of this guidance to specific securitized interests in prepayable financial assets.

815-15-25-37

The conditions in paragraph 815-15-25-26(b) do not apply to an embedded call option in a hybrid instrument containing a debt host contract if the right to accelerate the settlement of the debt can be exercised only by the debtor (the issuer or the borrower). This guidance does not affect the application of the condition in paragraph 815-15-25-26(a) or the application of paragraphs

815-15-25-41 through 25-43

. In addition, this guidance does not apply to other embedded derivative features that may be present in the same hybrid instrument.

815-15-25-38

The conditions in paragraph 815-15-25-26(b) apply only to situations that meet the two conditions specified in paragraph 815-15-25-26(b)(1) through (b)(2) and for which the investor has the unilateral ability to obtain the right to receive the high rate of return specified in those paragraphs. If the embedded derivative is an option rather than a forward contract, it is important to analyze whether the investor is the holder of that option. For an embedded call option, the issuer or borrower (and not the investor) is the holder, and thus only the issuer (borrower) can exercise the option. Consequently, the investor does not have the unilateral ability to obtain the right to receive the high rate of return, which is contingent on the issuer's exercise of the embedded call option.

815-15-25-39

Paragraph 815-15-55-25 provides implementation guidance on the application of this guidance to specific debt instruments.

815-15-25-40

Paragraph superseded by Accounting Standards Update No. 2016-06.

815-15-25-41

Call (put) options that do not accelerate the repayment of principal on a debt instrument but instead require a cash settlement that is equal to the price of the option at the date of exercise would not be considered to be clearly and closely related to the debt instrument in which it is embedded.

815-15-25-42

The following four-step decision sequence shall be followed in determining whether call (put) options that can accelerate the settlement of debt instruments shall be considered to be clearly and closely related to the debt host contract:

Step 1: Is the amount paid upon settlement (also referred to as the payoff) adjusted based on changes in an index? If yes, continue to Step 2. If no, continue to Step 3.
Step 2: Is the payoff indexed to an underlying other than interest rates or credit risk? If yes, then that embedded feature is not clearly and closely related to the debt host contract and further analysis under Steps 3 and 4 is not required. If no, then that embedded feature shall be analyzed further under Steps 3 and 4.
Step 3: Does the debt involve a substantial premium or discount? If yes, continue to Step 4. If no, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.
Step 4: Does a contingently exercisable call (put) option accelerate the repayment of the contractual principal amount? If yes, the call (put) option is not clearly and closely related to the debt instrument. If not contingently exercisable, further analysis of the contract under paragraph 815-15-25-26 is required, if applicable.

815-15-25-43

The preceding paragraph is distinct from paragraph 815-15-25-37, which addresses whether the conditions in paragraph 815-15-25-26(b) involving rate of return apply to certain call options exercisable only by the debtor. Paragraph 815-15-55-13 illustrates the application of the guidance in the preceding paragraph to nine illustrative debt instruments.

815-15-25-44

An embedded derivative that either (a) unilaterally enables one party to extend significantly the remaining term to maturity or (b) automatically extends significantly the remaining term triggered by specific events or conditions is not clearly and closely related to the interest rate on a debt instrument unless the interest rate is concurrently reset to the approximate current market rate for the extended term and the debt instrument initially involved no significant discount. Thus, if there is no reset of interest rates, the embedded derivative is not clearly and closely related to the host contract. That is, a term-extending option cannot be used to circumvent the restriction in paragraph 815-15-25-26 regarding the investor's not recovering substantially all of its initial recorded investment.

815-15-25-45

The preceding paragraph does not provide guidance for determining whether term-extending options in nondebt host contracts are clearly and closely related to the host contract, as discussed in paragraph 815-15-25-1(a). A term-extending option in a nondebt host contract can have a significantly different effect than a term-extending option in a debt host contract. Nondebt contracts (as well as debt contracts) that contain embedded term-extension features shall be evaluated under paragraph 815-15-25-1 to determine whether the term-extension feature is a derivative instrument that shall be accounted for separately.

815-15-25-46

The creditworthiness of the debtor and the interest rate on a debt instrument shall be considered to be clearly and closely related. Thus, for debt instruments that have the interest rate reset in the event of any of the following conditions, the related embedded derivative shall not be separated from the host contract:

a
Default (such as violation of a credit-risk-related covenant)
b
A change in the debtor's published credit rating
c
A change in the debtor's creditworthiness indicated by a change in its spread over U.S. Treasury bonds.

815-15-25-47

If an instrument incorporates a credit risk exposure that is different from the risk exposure arising from the creditworthiness of the obligor under that instrument, such that the value of the instrument is affected by an event of default or a change in creditworthiness of a third party (that is, an entity that is not the obligor), then the economic characteristics and risks of the embedded credit derivative are not clearly and closely related to the economic characteristics and risks of the host contract, even though the obligor may own securities issued by that third party. This guidance shall be applied to all other arrangements that incorporate credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. This guidance does not affect the accounting for a nonrecourse debt arrangement (that is, a debt arrangement in which, in the event that the debtor does not make the payments due under the loan, the creditor has recourse solely to the specified property pledged as collateral).

815-15-25-48

The changes in fair value of a commodity (or other asset) and the interest yield on a debt instrument are not clearly and closely related. Thus, a commodity-related derivative instrument embedded in a commodity-indexed debt instrument shall be separated from the noncommodity host contract and accounted for as a derivative instrument.

815-15-25-49

The changes in fair value of an equity interest and the interest yield on a debt instrument are not clearly and closely related. Thus, an equity-related derivative instrument embedded in an equity-indexed debt instrument (whether based on the price of a specific common stock or on an index that is based on a basket of equity instruments) shall be separated from the host contract and accounted for as a derivative instrument.

815-15-25-50

The interest rate and the rate of inflation in the economic environment for the currency in which a debt instrument is denominated shall be considered to be clearly and closely related. Thus, nonleveraged inflation-indexed contracts (debt instruments, capitalized lease obligations, pension obligations, and so forth) shall not have the inflation-related embedded derivative separated from the host contract.

815-15-25-51

The changes in fair value of an equity interest and the interest rates on a debt instrument are not clearly and closely related. Thus, for a debt security that is convertible into a specified number of shares of the debtor's common stock or another entity's common stock, the embedded derivative (that is, the conversion option) shall be separated from the debt host contract and accounted for as a derivative instrument provided that the conversion option would, as a freestanding instrument, be a derivative instrument subject to the requirements of this Subtopic. (For example, if the common stock was not readily convertible to cash, a conversion option that requires purchase of the common stock would not be accounted for as a derivative instrument.) That accounting applies only to the holder (investor) if the debt is convertible to the debtor's common stock because, under paragraph 815-10-15-74(a), a separate option with the same terms would not be a derivative instrument for the issuer.

815-15-25-51A

An embedded derivative feature that exposes the holder of a beneficial interest in a tranche of a securitized financial instrument to the possibility (however remote) of being required to make potential future payments (not merely receive reduced cash inflows) shall be considered to be not clearly and closely related to the economic characteristics and risks of the host contract and, thus, meet the criterion in paragraph 815-15-25-1(a).

Entity Unable to Reliably Identify and Measure Embedded Derivative

815-15-25-52

An entity that enters into sophisticated investment and funding strategies such as structured notes or other contracts with embedded derivatives should be able to obtain the information necessary to reliably identify and measure the separate components. It should be unusual that an entity would conclude that it cannot reliably separate an embedded derivative from its host contract.

815-15-25-53

If an entity cannot reliably identify and measure the embedded derivative that paragraph 815-15-25-1 requires be separated from the host contract, paragraphs 815-15-30-1(b) and 815-15-35-2 require that the entire contract be measured at fair value with gain or loss recognized in earnings, but that contract may not be designated as a hedging instrument pursuant to Subtopic 815-20.

Host Contract After Separation

815-15-25-54

If an embedded derivative is separated from its host contract, the host contract shall be accounted for based on GAAP applicable to instruments of that type that do not contain embedded derivatives.

815-15-30Initial Measurement

Source downloaded: 2026-09-10T01:36:11.044Z.Record version e4a95ec3e16b. Effective date must be checked in the source.

Hybrid Instruments That Are Not Separated

815-15-30-1

An entity shall measure both of the following initially at fair value:

a
A hybrid financial instrument that under paragraph 815-15-25-1 would be required to be separated into a host contract and a derivative instrument that an entity irrevocably elects to initially and subsequently measure in its entirety at fair value (with changes in fair value recognized in earnings)
b
An entire hybrid instrument if an entity cannot reliably identify and measure the embedded derivative that paragraph 815-15-25-1 requires be separated from the host contract.

Hybrid Instruments That Are Separated

815-15-30-2

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 shall be used to determine the carrying values of the host contract component and the embedded derivative component of a hybrid instrument if separate accounting for the embedded derivative is required by this Subtopic. (Note that Section 815-15-25 allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation.)

815-15-30-3

The objective is to estimate the fair value of the derivative features separately from the fair value of the nonderivative portions of the contract. Estimates of fair value shall reflect all relevant features of each component. For example, an embedded purchased option that expires if the contract in which it is embedded is prepaid would have a different value than an option whose term is a specified period that is not subject to truncation.

815-15-30-4

In separating a non-option embedded derivative from the host contract under paragraph 815-15-25-1, the terms of that non-option embedded derivative shall be determined in a manner that results in its fair value generally being equal to zero at the inception of the hybrid instrument. Because a loan and an embedded derivative can be bundled in a structured note that could have almost an infinite variety of stated terms, it is inappropriate to necessarily attribute significance to every one of the note's stated terms in determining the terms of the non-option embedded derivative. If a non-option embedded derivative has stated terms that are off-market at inception, that amount shall be quantified and allocated to the host contract because it effectively represents a borrowing. (This paragraph does not address the bifurcation of the embedded derivative by a holder who has acquired the hybrid instrument from a third party after the inception of that hybrid instrument.) The non-option embedded derivative shall contain a notional amount and an underlying consistent with the terms of the hybrid instrument. Artificial terms shall not be created to introduce leverage, asymmetry, or some other risk exposure not already present in the hybrid instrument. Generally, the appropriate terms for the non-option embedded derivative will be readily apparent. Often, simply adjusting the referenced forward price (pursuant to documented legal terms) to be at the market for the purpose of separately accounting for the embedded derivative will result in that non-option embedded derivative having a fair value of zero at inception of the hybrid instrument.

815-15-30-5

In separating a non-option embedded derivative from the host contract under paragraph 815-15-25-1 if the holder has acquired the hybrid instrument in a secondary market after the inception of the hybrid instrument, the terms of the embedded derivative shall be determined by the holder so as to result in the derivative instrument 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 shall not be affected by whether it purchased the hybrid instrument at inception or after inception in a secondary market.

815-15-30-6

The terms of an option-based embedded derivative shall not be adjusted to result in the embedded derivative being at the money at the inception of the hybrid instrument. In separating an option-based embedded derivative from the host contract under paragraph 815-15-25-1, the strike price of the embedded derivative shall be based on the stated terms documented in the hybrid instrument. As a result, the option-based embedded derivative at inception may have a strike price that does not equal the market price of the asset associated with the underlying. The guidance in this paragraph addresses both of the following:

a
The bifurcation of the option-based embedded derivative by a holder who has acquired the hybrid instrument from a third party either at inception or after inception of that hybrid instrument
b
The bifurcation of the option-based embedded derivative by the issuer when separate accounting for that embedded derivative is required.

815-15-35Subsequent Measurement

Source downloaded: 2026-09-10T01:36:12.754Z.Record version eb28e04c0631. Effective date must be checked in the source.

Hybrid Instruments That Are Not Separated

815-15-35-1

If an entity irrevocably elected to initially and subsequently measure a hybrid financial instrument in its entirety at fair value, changes in fair value for that hybrid financial instrument shall be recognized in earnings. Paragraph 815-20-25-71(a)(3) states that the entire contract shall not be designated as a hedging instrument pursuant to Subtopic 815-20.

815-15-35-2

If an entity cannot reliably identify and measure the embedded derivative that paragraph 815-15-25-1 requires be separated from the host contract, the entire contract shall be measured subsequently at fair value with gain or loss recognized in earnings. Paragraph 815-20-25-71(a)(4) states that the entire contract shall not be designated as a hedging instrument pursuant to Subtopic 815-20.

Hybrid Instruments That Are Separated

815-15-35-2A

Paragraph 815-15-25-1 requires that an embedded derivative be separated from the host contract and accounted for as a derivative instrument pursuant to Subtopic 815-10 if and only if all of the criteria in paragraph 815-15-25-1 are met.

815-15-35-3

If the host contract component of a 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 shall not exceed the overall fair value of the hybrid instrument.

Embedded Conversion Option That No Longer Meets Bifurcation Criteria

815-15-35-4

If an embedded conversion option in a convertible debt instrument no longer meets the bifurcation criteria in this Subtopic, an issuer shall account for the previously bifurcated conversion option by reclassifying the carrying amount of the liability for the conversion option (that is, its fair value on the date of reclassification) to shareholders' equity. Any debt discount recognized when the conversion option was bifurcated from the convertible debt instrument shall continue to be amortized.

815-15-40Derecognition

Source downloaded: 2026-09-10T01:36:16.615Z.Record version 3fdd112c00d4. Effective date must be checked in the source.

Embedded Conversion Option that No Longer Meets Bifurcation Criteria

815-15-40-1

If a holder exercises a conversion option for which the carrying amount has previously been reclassified to shareholders' equity pursuant to paragraph 815-15-35-4, the issuer shall recognize any unamortized discount remaining at the date of conversion immediately as interest expense.

If a convertible debt instrument with a conversion option for which the carrying amount has previously been reclassified to shareholders' equity pursuant to the guidance in paragraph 815-15-35-4 is extinguished for cash (or other assets) before its stated maturity date, the entity shall do both of the following:

a
The portion of the reacquisition price equal to the fair value of the conversion option at the date of the extinguishment shall be allocated to equity.
b
The remaining reacquisition price shall be allocated to the extinguishment of the debt to determine the amount of gain or loss.

815-15-45Other Presentation Matters

Source downloaded: 2026-09-10T01:36:19.646Z.Record version de64176b5654. Effective date must be checked in the source.

815-15-45-1

In each statement of financial position presented, an entity shall report hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1 in a manner that separates those reported fair values from the carrying amounts of assets and liabilities subsequently measured using another measurement attribute on the face of the statement of financial position. To accomplish that separate reporting, an entity may do either of the following:

a
Display separate line items for the fair value and non-fair-value carrying amounts
b
Present the aggregate of the fair value and non-fair-value amounts and parenthetically disclose the amount of fair value included in the aggregate amount.

815-15-45-2

If an entity has designated a financial liability under the fair value election in accordance with paragraphs

815-15-25-4 through 25-6

, the entity shall apply the guidance in paragraph 825-10-45-5 on the presentation of changes in the liability's fair value that result from changes in instrument-specific credit risk.

815-15-50Disclosure

Source downloaded: 2026-09-10T01:36:22.333Z.Record version 14a1585e26e6. Effective date must be checked in the source.

Hybrid Instruments That Are Not Separated

815-15-50-1

For those hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1, an entity shall also disclose the information specified in paragraphs

825-10-50-28 through 50-32

815-15-50-2

An entity shall provide information that will allow users to understand the effect of changes in the fair value of hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1 on earnings (or other performance indicators for entities that do not report earnings).

Transition date:(P) December 16, 2027; (N) December 16, 2028Transition guidance:

270-10-65-1For interim and annual reporting periods, an entity shall provide information that will allow users to understand the effect of changes in the fair value of hybrid financial instruments measured at fair value under the election and under the practicability exception in paragraph 815-15-30-1 on earnings (or other performance indicators for entities that do not report earnings).

Embedded Conversion Option that Is No Longer Bifurcated

815-15-50-3

An issuer shall disclose both of the following for the period in which an embedded conversion option previously accounted for as a derivative instrument under this Subtopic no longer meets the separation criteria under this Subtopic:

a
A description of the principal changes causing the embedded conversion option to no longer require bifurcation under this Subtopic
b
The amount of the liability for the conversion option reclassified to stockholders' equity.

815-15-55Implementation Guidance and Illustrations

Source downloaded: 2026-09-10T01:36:24.773Z.Record version 7b3933470915. Effective date must be checked in the source.

Implementation Guidance

815-15-55-1

Insurance contracts that provide coverage for various types of property and casualty exposure are commonly executed between U.S.-based insurance entities and multinational corporations that have operations in foreign countries. The contracts may be structured to provide for payment of claims in the functional currency of the insurer or in the functional currency of the entity experiencing the loss and will typically specify the exchange rate to be utilized in calculating loss payments.

815-15-55-2

Consider a contract that provides for the payment of losses in U.S. dollars (that is, the functional currency of the insurer). Losses are reported to the insurance entity in the functional currency of the entity experiencing the loss, but losses are paid by the insurer in U.S. dollars. From the perspective of the insurer, the contract terms may provide that the rate of exchange to be used to convert the losses from the functional currency of the foreign entity to the U.S. dollar for purposes of claim payments be one of the following:

a
The rate of exchange as of the settlement date (payment date) of the claim
b
The rate of exchange as of the loss occurrence date
c
The rate of exchange at inception of the contract.

The contract described in this guidance does not qualify as traditional insurance under paragraph 815-10-15-53(b) because it contains a foreign currency element.

815-15-55-3

Because the insurance entity does not record a claim liability in accordance with Subtopic 944-40 until losses are incurred, no foreign-currency-denominated liability exists (that would otherwise be subject to Subtopic 830-20, as contemplated by paragraph 815-15-15-10) during the period between the inception of the insurance contract and the loss occurrence date.

815-15-55-4

Insurance contracts are financial instruments that are not covered by the scope exception in paragraph 815-15-15-10 that applies to nonfinancial contracts; however, that paragraph applies to this situation in which a normal insurance contract involves payment in the functional currency of either of the two parties to the contract. The insurance contracts described in this guidance are covered by the exception in paragraph 815-15-15-10, because the insurance contracts do not give rise to a recognized asset or liability that would be measured under Subtopic 830-20 until an amount becomes receivable or payable under the contract. Therefore, as discussed in paragraph 815-15-15-20, the exception in paragraph 815-15-15-10 also applies to insurance contracts that involve payment of losses in the functional currency of either of the two parties to the contract.

815-15-55-5

The following guidance addresses application of one or more of the bifurcation criteria in paragraph 815-15-25-1.

815-15-55-6

The following guidance addresses application of the separate instrument criterion in paragraph 815-15-25-1(c).

815-15-55-7

Lease contracts that include variable lease payments based on certain sales of the lessee would not have the embedded derivative that is related to the variable lease payment separated from the host contract because, under paragraph 815-10-15-59(d), a non-exchange-traded contract whose underlying is specified volumes of sales by one of the parties to the contract would not be subject to the requirements of Subtopic 815-10.

815-15-55-8

Under an example participating mortgage, the investor receives a below-market interest rate and is entitled to participate in the appreciation in the fair value of the project that is financed by the mortgage upon sale of the project, at a deemed sale date, or at the maturity or refinancing of the loan. The mortgagor must continue to own the project over the term of the mortgage.

815-15-55-9

This instrument has a provision that entitles the investor to participate in the appreciation of the referenced real estate (the project). However, a separate contract with the same terms would be excluded by the exception in paragraph 815-10-15-59(b) because settlement is based on the value of a nonfinancial asset of one of the parties that is not readily convertible to cash. (This Subtopic does not modify the guidance in Subtopic 470-30.)

815-15-55-10

Paragraph 310-10-05-9 explains that loans granted to acquire operating properties sometimes grant the lender a right to participate in expected residual profit from the sale or refinancing of the property. An equity kicker (or expected residual profit) would typically not be separated from the host contract and accounted for as an embedded derivative because paragraph 815-15-25-1(c) exempts a hybrid contract from bifurcation if a separate instrument with the same terms as the embedded equity kicker is not a derivative instrument subject to the requirements of this Subtopic. Under paragraph 815-10-15-59(b), an embedded equity kicker would typically not be subject to the requirements of this Subtopic because the separate instrument with the same terms is not exchange traded and is indexed to nonfinancial assets that are not readily convertible to cash. Similarly, if an equity kicker is based on a share in net earnings or operating cash flows, it would also typically qualify for the scope exception in paragraph 815-10-15-59(d). If the embedded derivative does not need to be accounted for separately under this Subtopic, the Acquisition, Development, and Construction Arrangements Subsections of Subtopic 310-10 shall be applied.

815-15-55-11

A loan with an equity kicker of more than 50 percent of net earnings that is considered to be an investment in real estate under the Acquisition, Development, and Construction Arrangements Subsections of Subtopic 310-10 would not be analyzed under this Subtopic as a host loan contract and an embedded equity kicker derivative.

815-15-55-12

Paragraphs

815-10-55-37 through 55-39

provide guidance on dual-trigger insurance contracts and whether such a contract, in its entirety, is a derivative instrument subject to the requirements of Subtopic 815-10. If a contract issued by an insurance entity involves essentially assured amounts of cash flows based on insurable events that are highly probable of occurrence (as discussed in paragraph 815-10-15-55(c)), an embedded derivative related to changes in the separate pre-identified variable for that portion of the contract would be required to be separately accounted for as a derivative instrument.

815-15-55-13

The following table demonstrates the application of the four-step decision sequence in paragraph 815-15-25-42 for determining whether call options and put options that can accelerate the settlement of debt instruments should be considered to be clearly and closely related to the debt host contract under the criterion in paragraph 815-15-25-1(a).

Instrument "Indexed Payoff? (Steps 1 and 2)" "Substantial Discount or Premium? (Step 3)" "Contingently Exercisable? (Step 4)" "Embedded Option Clearly and Closely Related?" "1. Debt that is issued at a substantial discount is callable at any time during its 10-year term. If the debt is called, the investor receives the par value of the debt plus any unpaid and accrued interest." No. Yes. No. "The embedded call option is clearly and closely related to the debt host contract because the payoff is not indexed, and the call option is not contingently exercisable. " "2. Debt that is issued at par is callable at any time during its term. If the debt is called, the investor receives the greater of the par value of the debt or the market value of 100,000 shares of XYZ common stock (an unrelated entity)." "Yes, based on an equity price." N/A. Analysis not required. N/A. Analysis not required. The embedded call option is not clearly and closely related to the debt host contract because the payoff is indexed to an equity price. "3. Debt that is issued at par is puttable if the Standard and Poor's S&P 500 Index increases by at least 20 percent. If the debt is put, the investor receives the par amount of the debt adjusted for the percentage increase in the S&P 500." "Yes, based on an equity index (S&P 500)." N/A. Analysis not required. N/A. Analysis not required. The embedded put option is not clearly and closely related to the debt host contract because the payoff is indexed to an equity price. 4. Debt that is issued at a substantial discount is puttable at par if London Interbank Offered Rate (LIBOR) either increases or decreases by 150 basis points. No. Yes. "Yes, contingent on a movement of LIBOR of at least 150 basis points." The put option is not clearly and closely related to the debt host contract because the debt was issued at a substantial discount and the put option is contingently exercisable. 5. Debt that is issued at a substantial discount is puttable at par in the event of a change in control. No. Yes. "Yes, contingent on a change in control." The put option is not clearly and closely related to the debt host contract because the debt was issued at a substantial discount and the put option is contingently exercisable. "6. Zero coupon debt is issued at a substantial discount and is callable in the event of a change in control. If the debt is called, the issuer pays the accreted value (calculated per amortization table based on the effective interest rate method)." No. Yes. "Yes, contingent on a change in control, but since the debt is callable at accreted value, the call option does not accelerate the repayment of principal." "The call option is clearly and closely related to the debt host contract. Although the debt was issued at a substantial discount and the call option is contingently exercisable, the call option does not accelerate the repayment of principal because the debt is callable at the accreted value." 7. Debt that is issued at par is puttable at par in the event that the issuer has an initial public offering. No. No. N/A. Analysis not required. The embedded put option is clearly and closely related to the debt host contract because the debt was issued at par (not at a substantial discount) and is puttable at par. Paragraph 815-15-25-26 does not apply. "8. Debt that is issued at par is puttable if the price of the common stock of Entity XYZ (an entity unrelated to the issuer or investor) changes by 20 percent. If the debt is put, the investor will be repaid based on the value of Entity XYZ's common stock." "Yes, based on an equity price (price of Entity XYZ's common stock)." N/A. Analysis not required. N/A. Analysis not required. The embedded put option is not clearly and closely related to the debt host contract because the payoff is indexed to an equity price. "9. Debt is issued at a slight discount and is puttable if interest rates move 200 basis points. If the debt is put, the investor will be repaid based on the S&P 500." "Yes, based on an equity index (S&P 500)." N/A. Analysis not required. N/A. Analysis not required. The embedded put option is not clearly and closely related to the debt host contract because the payoff is based on an equity index.

815-15-55-14

The following guidance addresses application of the bifurcation criteria in paragraph 815-15-25-1 to various transactions and is organized as follows:

a
Volumetric production payments
b
Interest-rate-related underlyings—call options that are exercisable only by the debtor
c
Remarketable put bonds
d
Variable annuity products in general
e
Payment alternatives for variable annuity contracts
f
Equity-indexed annuity contracts
g
Equity-indexed life insurance contracts.

815-15-55-15

The embedded derivative provisions of this Subtopic apply to the accounting by all parties for a volumetric production payment (see paragraph 932-360-55-2) for which the quantity of the commodity that will be delivered is reliably determinable.

815-15-55-16

A volumetric production payment is not itself a standalone derivative instrument because, like the contract in paragraphs

815-10-55-74 through 55-76

, it does not have the characteristic of a derivative instrument discussed in paragraph 815-10-15-83(b)—that is, a smaller or no initial net investment.

815-15-55-17

Although it is not derivative instrument, a volumetric production payment shall be analyzed under paragraph 815-15-25-1. That analysis would typically indicate that such a volumetric production payment effectively is a hybrid instrument composed of a host debt instrument embedded with a commodity forward contract.

815-15-55-18

The criterion in paragraph 815-15-25-1(b) is met because a volumetric production payment is not remeasured at fair value under otherwise applicable generally accepted accounting principles (GAAP) with changes in fair value reported currently in earnings.

815-15-55-19

The embedded commodity forward contract meets the criterion in paragraph 815-15-25-1(a) because commodity prices are not clearly and closely related to interest rates on the debt host contract.

815-15-55-20

Accordingly, if a separate instrument with the same terms as the commodity forward contract would be a derivative instrument subject to the requirements of this Subtopic, the embedded commodity forward contract would meet the criterion in paragraph 815-15-25-1(c) and shall be accounted for separately. (Note that Section 815-15-25 allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. However, Section 815-15-25 does not apply to hybrid instruments that are not financial instruments, such as nonfinancial instruments that require volumetric production payments.)

815-15-55-21

However, the embedded commodity forward contract may nevertheless be eligible to qualify for the normal purchases and normal sales exception as discussed beginning in paragraph 815-10-15-22 and, if so, would not be subject to the accounting requirements of Subtopic 815-10 for the party to whom it is a normal purchase or a normal sale. If it were a normal sale for an oil- or gas-producing entity, the entire related volumetric production payment would be accounted for under Topic 932.

815-15-55-22

If the embedded commodity forward contract does not qualify for the normal purchases and normal sales exception, it may qualify for designation as the hedging instrument in an all-in-one hedge, as discussed in paragraph 815-20-25-22.

815-15-55-23

If the quantity of the commodity that will be delivered under a volumetric production payment arrangement is not reliably determinable, the embedded commodity forward contracts in such volumetric production payment arrangements are considered not to contain a notional amount as that term is used in Subtopic 815-10. Such a circumstance can occur when the oil or gas volumetric production payments relate to the production of a single well (or relatively unproven properties) and the volume under the contract is relatively large, and thereby involve significant reserve risk with respect to the receipt of the entire quantity specified in the contract.

815-15-55-24

If the embedded commodity forward contract is not subject to the requirements of Subtopic 815-10, the entire related volumetric production payment would be accounted for under Topic 932.

815-15-55-25

Application of the guidance in paragraphs

815-15-25-37 through 25-39

to specific debt instruments is provided in the following table.

Instrument "Paragraph 815-15-25-26(b) Applicable to the Embedded Call Option?" Comments 1. An unsecured commercial loan that includes a prepayment option that permits the loan to be prepaid by the borrower at a fixed amount at any time at a specified premium over the initial principal amount of the loan. No. The commercial loan is prepayable only at the option of the borrower. 2. A fixed-rate debt instrument issued at a discount that is callable at par value at any time during its 10-year term. No. The fixed-rate debt instrument is callable at par value only by the issuer. 3. A fixed-rate 10-year bond that contains a call option that permits the issuer to prepay the bond at any time after issuance by paying the investor an amount equal to all the future contractual cash flows discounted at the then-current Treasury rate plus 45 basis points. The spread over the Treasury rate for the borrower at the issuance of the bond was 300 basis points. No. The fixed-rate 10-year bond is callable only at the option of the issuer. 4. A 5-year debt instrument issued at par that has a quarterly coupon equal to 15 percent minus 3 times 3-month LIBOR and that includes a call provision that allows the issuer to call the debt at any time at a specified premium over par. No. "The instrument is callable only by the issuer, so the embedded call option feature will not be subject to the conditions in paragraph 815-15-25-26(b). However, the conditions in that paragraph are still applicable to the levered index feature of the debt." "5. A fixed rate debt instrument is issued at par and is callable at any time during its 10-year term. If the debt is called, the investor receives the greater of the par value of the debt or the market value of 100,000 shares of XYZ common stock (an unrelated entity)." No. "The instrument is callable only by the issuer, so the embedded call option feature will not be subject to the conditions in paragraph 815-15-25-26(b). However, the embedded call option is not considered clearly and closely related to the debt host contract because the payoff is based on an equity price." "6. A mortgage-backed security is issued, whereby cash flows associated with principal payments (including full or partial prepayments and related penalties) received on the related mortgage loans are passed through to the mortgage-backed security investors." Not applicable (see comments). "Although the related mortgage loans are prepayable, and thus each contain a separate embedded call option, the mortgage-backed security itself does not contain an embedded call option. While the mortgage-backed security investor is subject to prepayment risk, the mortgage-backed security issuer has the obligation (not the option) to pass through cash flows from the related mortgage loans to the mortgage-backed security investors. Therefore, mortgage-backed securities are not within the scope of this guidance. Paragraphs 815-15-25-33 through 25-36 address the application of paragraph 815-15-25-26(b) to securitized interests in prepayable financial assets."

815-15-55-26

The following guidance discusses remarketable put bond structures involving three parties—a debtor, an investor (creditor), and an investment bank—and the required accounting by the debtor and the investor for each of the features discussed.

815-15-55-27

A standard put bond has all of the following characteristics:

a
A debtor issues a contract comprising a bond and a written put option.
b
The option allows the investor to put the bond back to the debtor at a specific date in exchange for the bond's par value.
c
In exchange for giving the investor the right to redeem the bond at par before maturity, the debtor pays a lower effective interest rate than would be demanded for a nonputtable bond.

815-15-55-28

In addition, the rate on the bond may reset at the put date (resettable put bonds), and the bond may also involve a call option (callable, resettable put bonds).

815-15-55-29

A remarketable put bond is a puttable bond that generally has the following additional features:

a
An investment bank obtains a call option—a right to buy the bond from the investor on the put date for the par amount.
b
The investment bank usually is either the underwriter of the bond issuance or an affiliate of the underwriter.
c
The bond will automatically be put back to the debtor if the investment bank does not exercise its call option to purchase the bond.
d
The strike prices and the exercise dates of the investor's written call option and purchased put option are the same.
e
The exercise dates are before the stated maturity of the bond.
f
The bond has an interest-rate-reset feature under which, if the bond is not put, the bond's contractual interest rate for the remaining term to maturity will reset at the put date based on the sum of the following:
1. 1
  The yield, at the issuance date of the puttable bond, of U.S. Treasury bonds of the same remaining maturity as the bond
2. 2
  The debtor's credit spread as of the put date.
g
The proceeds from issuance exceed the par amount of the bond, net of issuance costs.

815-15-55-30

It is assumed for purposes of this discussion that the interest-rate-reset feature does not trigger the condition in paragraph 815-15-25-26(a). The premium over par compensates the debtor for the interest-rate-reset feature. The premium generally is less than 10 percent of the par amount.

815-15-55-31

Economically, one of two scenarios will occur:

a
If market interest rates increase, both of the following will occur:
1. 1
  The fair value of the bond (absent the effect of the put option) will decrease.
2. 2
  The put option is in the money; therefore, the investors will put the bonds to the debtor.
b
If market interest rates decrease, both of the following will occur:
1. 1
  The fair value of the bond (absent the effect of the call option) will increase.
2. 2
  The call option is in the money; therefore, the investment bank will call the bonds from investors and resell the repriced bonds in the market at a premium.

815-15-55-32

The following guidance describes six remarketable put bond structures and three additional features that may accompany certain structures.

815-15-55-33

Structure 1 has all of the following features:

a
A debtor issues a resettable, puttable bond to an investment bank.
b
The investment bank sells to an investor that resettable, puttable bond with an attached call option.
c
The attached call option is a written option from the perspective of the investor and a purchased option from the perspective of the investment bank.

815-15-55-34

That is, the investor buys a resettable, puttable bond and simultaneously writes a call option giving the investment bank the right to call the bond and take advantage of the interest-rate-reset feature.

815-15-55-35

Structure 1 is analyzed as follows:

a
Investment bank's held call option. The debtor should not account for the call option purchased by the investment bank from the investor. The debtor is not a party to the call option. The investor's accounting for Structure 1 is addressed in Example 1, Case A (see paragraph 815-10-55-67), which requires that an option that is added to a debt instrument by a third party contemporaneously with or after the issuance of the debt instrument be separately accounted for as a derivative instrument by the investor. That is, it shall be reported at fair value with changes in value recognized currently in earnings. The investment bank shall also account for a freestanding purchased call option.
b
Investor's written call option. The carrying value of the investor's attached freestanding written call option to the investment bank should be its fair value in accordance with paragraphs 815-10-30-1 and 815-10-35-1. The remaining proceeds would be allocated to the carrying amount of the puttable bond.
c
Investor's held put option. Neither the debtor nor the investor is required to account separately for the embedded put option written by the debtor to the investor. Under paragraphs
815-15-25-41 through 25-43
, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

815-15-55-36

Structure 2 has all of the following features:

a
A debtor issues a resettable, puttable bond to an investor.
b
Contemporaneously, the investor writes a freestanding call option that permits the debtor to call the bond on the put date.
c
The debtor immediately sells the purchased call option to an investment bank.

815-15-55-37

Structure 2 is analyzed as follows:

a
Investment bank's held call option. The debtor should not account separately for the call option that is purchased from the investor after it is transferred to the investment bank. The debtor is no longer a party to the call option. The investor's accounting for Structure 2 is addressed in Example 1, Case B (see paragraph 815-10-55-70), which indicates that the investor's written call option is a separate freestanding derivative instrument that shall be reported at fair value with changes in value recognized currently in earnings. The investment bank shall also account for a freestanding purchased call option.
b
Investor's written call option. The carrying value of the investor's freestanding written call option to the investment bank should be its fair value in accordance with paragraphs 815-10-30-1 and 815-10-35-1. The remaining proceeds would be allocated to the carrying amount of the puttable bond.
c
Investor's held put option. Neither the debtor nor the investor is required to account separately for the embedded put option written by the debtor to the investor. Under paragraphs
815-15-25-41 through 25-43
, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

815-15-55-38

Structure 3 has all of the following features:

a
A debtor issues a resettable bond to an investor.
b
The bond is puttable by the investor and callable by the debtor.
c
The terms of the agreement stipulate that if the debtor does not exercise its purchased call option, the investor's purchased put option is automatically exercised.
d
Contemporaneously, the debtor writes a separate, freestanding call option to an investment bank giving the investment bank the right to require the debtor to call the bond from the investor and deliver the bond to the investment bank.
e
To deliver the bond to the investment bank, the debtor must obtain the bond from the investor pursuant to either its purchased call option or its written put option.
f
The debtor has a resulting obligation to make the investment bank whole if it fails to deliver the bond, and the investment bank has no right to pursue the investor if the investor fails to deliver the bond to the debtor.

815-15-55-39

Structure 3 is analyzed as follows:

a
Investment bank's held call option. The debtor shall account separately for the freestanding call option written to the investment bank, and the investment bank shall account for a freestanding purchased call option, in accordance with the guidance for a derivative instrument in Subtopic 815-10. The investor is not a party to that freestanding written call option and therefore should not account for that option. In addition to the freestanding call option held by the investment bank, Structure 3 also involves an embedded call option written by the investor to the debtor. That embedded call option is not required to be accounted for separately by either the debtor or the investor. Under paragraphs
815-15-25-41 through 25-43
, that embedded call option is considered clearly and closely related to the economic characteristics of the bond. Consistent with the guidance in paragraph 815-20-25-43(c)(7), the debtor may not designate its freestanding call option written to the investment bank as a hedge of its embedded call option purchased from the investor. Because the terms of the contractual agreement require the debtor to settle its obligation to the investor on the embedded options' exercise date, that exercise date is essentially the bond's actual maturity date. Thus, in this structure, there is no embedded option in the bond that would qualify as the hedged item in a fair value hedge in which the hedging instrument is the debtor's freestanding written call option to the investment bank. However, the debtor may designate its freestanding written call option as a hedge of another asset or liability provided that all applicable requirements, including those in paragraph 815-20-25-94, are met.
b
Investor's held put option. Neither the debtor nor the investor is required to account separately for the embedded put option written by the debtor to the investor. Under paragraphs
815-15-25-41 through 25-43
, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

815-15-55-40

Structure 4 has all of the following features:

a
A debtor issues resettable, puttable bonds to a trust.
b
The trust issues beneficial interests that mature on the put date.
c
The trust also writes a call option to an investment bank giving the investment bank the right to call the bonds on the put date.

815-15-55-41

If market interest rates fall, the investment bank will call the bonds and the trust will pay the call option proceeds (the par amount) to investors to settle the maturing beneficial interests.

815-15-55-42

If market interest rates increase, the trust will put the bonds back to the debtor and will pay the put option proceeds (the par amount) to investors to settle the maturing beneficial interests.

815-15-55-43

Structure 4 is analyzed as follows:

a
Investment bank's held call option. Neither the debtor nor the investor should account for the call option purchased by the investment bank from the trust because neither is a party to that call option. (However, if either the debtor or the investor is required to consolidate the trust, that consolidation will require recognition of the call option written by the trust to the investment bank.) The investment bank shall account for a freestanding purchased call option.
b
Investor's held put option. Neither the debtor nor the investor should account separately for the embedded put option written by the debtor to the trust. From the debtor's perspective, the put option is considered clearly and closely related to the economic characteristics of the bond under paragraphs
815-15-25-41 through 25-43
because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent. The investor is not a party to the embedded put option; rather, the investor simply purchased beneficial interests that mature on the put date.

815-15-55-44

Structure 5 has all of the following characteristics:

a
A debtor issues to an investor a bond that is both puttable (by the investor) and callable (by the holder of the option).
b
As part of the transaction, the investment bank acquires the exclusive right to purchase the bond from the investor in the future and to remarket the repriced bond.
c
The investment bank's right to purchase the bond from the investor is set forth in the note or the indenture itself and in a separate document (a remarketing agreement) that is not part of the indenture, and is also described in the prospectus supplement.
d
The explicit inclusion in the indenture of the investment bank's right to purchase the bond is designed to obligate initial and future investors to deliver the bond in response to the investment bank's exercise of its right.
e
When the bond is issued, the trustee, in conformity with the transaction documents, shall view the investment bank as the only party with a right to call the bond from the investor at the call-put date. Thus, the trustee does not require any involvement by the debtor when enforcing the investment bank's right to purchase the bond from the investor.
f
The debtor's only remaining obligation is to pay interest at the reset rate if the bond remains outstanding.

815-15-55-45

Structure 5 is analyzed as follows:

a
Investment bank's held call option. The debtor should not account separately for the call option held by the investment bank. For accounting purposes, the transaction should be viewed as a purchase of a transferable, freestanding call option by the debtor from the investor and a concurrent transfer by the debtor of that option to the investment bank. Upon that transfer, the debtor is no longer a party to the call option and has surrendered its right to prepay the debt. The investment bank acquired the debtor's right to call the bond and relieved the debtor of the obligation to pay the investor the par amount of the bond upon exercise of the call option. The call option is a contract between the investment bank and the investor that permits the investment bank to purchase the bonds from the investor at par. From the investor's perspective, that contract is a freestanding written call option that shall be accounted for in accordance with paragraphs 815-10-25-1, 815-10-30-1, and
815-10-35-1 through 35-2
. That is consistent with the guidance in paragraph 815-10-15-7—an option on a bond incorporated into the terms of the bond at inception that, by the terms of the agreement, is exercisable by a party other than either the debtor or the investor should be considered an attached freestanding derivative instrument. The investment bank shall also account for a freestanding purchased call option.
b
Investor's written call option. The carrying value of the investor's freestanding written call option to the investment bank should be its fair value in accordance with paragraphs 815-10-30-1 and 815-10-35-1. In the remarketing format, the transfer of the purchased call option is concurrent with the issuance of the bond. The remaining proceeds would be allocated to the carrying amount of the puttable bond. The debtor recognizes no gain or loss upon the transfer of the option to the investment bank.
c
Investor's held put option. Neither the debtor nor the investor should account separately for the embedded put option written by the debtor to the investor. Under paragraphs
815-15-25-41 through 25-43
, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

815-15-55-46

Structure 6 has all of the following features:

a
A debtor issues to an investor a bond that is both puttable (by the investor) and callable (by the holder of the option).
b
The indenture and the note itself create an assignable right to purchase the bond from the investor and remarket the repriced bond.
c
A legal assignment of that right by the debtor to an investment bank, in exchange for a payment to the debtor, is executed as part of the underwriting process as an amendment to the note. The assignment typically occurs at the time the bond is issued.
d
Upon receipt of the notice of assignment (which typically occurs upon issuance of the bonds), the indenture trustee must view the assignee (that is, the investment bank) as the call option holder and does not require any involvement of the debtor when enforcing the assignee's right to call the bond from the investor.
e
The debtor's only remaining obligation is to pay interest at the reset rate.

815-15-55-47

Structure 6 is analyzed as follows:

a
Investment bank's held call option. The debtor is not required to account separately for the call option after its transfer to the investment bank. The debtor purchased a transferable freestanding call option from the investor and transferred that option to the investment bank. Therefore, after the transfer, the debtor is no longer a party to the call option and has surrendered its right to prepay the debt. The investment bank acquired the debtor's right to call the bond and relieved the debtor of the obligation to pay the investor the par amount of the bond upon exercise of the call option. Ultimately, the call option is a contract between the investment bank and the investor that permits the investment bank to purchase the bond from the investor at par. From the investor's perspective, that contract is a freestanding written call option that shall be accounted for in accordance with the guidance for a derivative instrument in Subtopic 815-10. That is consistent with the guidance in paragraph 815-10-15-7 that an option on a bond incorporated into the terms of the bond at inception that is explicitly transferable should be considered an attached, freestanding derivative instrument. The investment bank shall also account for a freestanding purchased call option.
b
Investor's written call option. The carrying value of the investor's freestanding written call option to the investment bank should be its fair value in accordance with paragraphs 815-10-30-1 and 815-10-35-1 with the remaining proceeds allocated to the carrying amount of the puttable bond. In the assignment format, the transfer of the purchased call option by the debtor to the investment bank may not be concurrent with the issuance of the bond. The debtor recognizes no gain or loss upon the transfer of the call option. In transactions involving a delay between the issuance of the bond and the transfer of the assignable call option to the investment bank, the allocation of the initial proceeds to the carrying value of the option would be equal to the fair value of the option. The remaining proceeds would be allocated to the carrying amount of the puttable bond. During any period of time between the initial issuance of the bond and the transfer of the call option to the investment bank, the call option shall be measured at fair value with changes in value recognized in earnings as required by paragraph 815-20-35-1. As a result of the requirement to measure the call option at fair value during the time period before it is assigned to the investment bank, the debtor would not recognize a gain or loss upon the assignment because the proceeds paid by the investment bank would be the option's current fair value on the date of the assignment, which would be the option's carrying amount at that point in time. Any change in the fair value of the option during the time period before it is assigned to the investment bank would be attributable to the passage of time and changes in market conditions.
c
Investor's held put option. Neither the debtor nor the investor should account separately for the embedded put option written by the debtor to the investor. Under paragraphs
815-15-25-41 through 25-43
, the put option is considered clearly and closely related to the economic characteristics of the bond because it simply accelerates the repayment of principal, involves no substantial premium or discount, and is not contingent.

815-15-55-48

A separate agreement may exist that allows the debtor to avoid the remarketing of the bond. That agreement permits the debtor, as of the reset date, to purchase either of the following:

a
The repriced bond from the investment bank at its then fair value
b
The unexercised call option held by the investment bank at its then fair value, which in turn would permit the debtor to purchase the bond at par from the investor.

815-15-55-49

The additional feature is a separate contract between the debtor and the investment bank. Specifically, it is a freestanding call option purchased by the debtor from the investment bank that permits the debtor to purchase either the repriced bond or the unexercised call option from the investment bank at its then fair value. The guidance for a derivative instrument in Subtopic 815-10 requires that all freestanding derivatives be measured at fair value with changes in value recognized in earnings. However, because the exercise price of the debtor's call option is the then fair value of the repriced bonds or the unexercised call option at the date of exercise, the option itself has a zero fair value. As a result, the asset or liability related to the derivative that would be recognized by the debtor as a result of applying the requirements of that Subtopic has a value of zero.

815-15-55-50

A separate agreement may exist under which the debtor writes an option to the investment bank that permits the investment bank to put its call option to the debtor at fair value if a specified contingency occurs (for example, a failed remarketing). That feature provides loss protection to the investment bank.

815-15-55-51

The additional feature is a separate contract between the debtor and the investment bank. Specifically, it is a freestanding put option written by the debtor to the investment bank. Accordingly, the feature should be accounted for as a freestanding derivative measured at fair value with changes in value recognized in earnings in accordance with the guidance for a derivative instrument in Subtopic 815-10. However, because the exercise price of the debtor's put option is the then fair value of the unexercised call option at the exercise date, the option itself has a zero fair value. As a result, the asset or liability related to the derivative that would be recognized by the debtor as a result of applying the requirements of that Subtopic has a value of zero.

815-15-55-52

Some arrangements provide recourse to the investment bank against the debtor for the fair value of the call option if the investor fails to deliver the bonds to the investment bank upon exercise of its call option. That feature provides loss protection to the investment bank.

815-15-55-53

The additional feature is a separate contract between the debtor and the investment bank. Although it is structured as a recourse agreement, the substance of the feature is similar to additional feature 2 in that it is a put option written by the debtor to the investment bank. Accordingly, the feature should be accounted for as a freestanding written put option measured at fair value with changes in value recognized in earnings in accordance with the guidance for a derivative instrument in Subtopic 815-10. However, because the exercise price of the debtor's put option is the then fair value of the unexercised call option at the date of exercise, the option itself has a zero fair value. As a result, the asset or liability related to the derivative that would be recognized by the debtor as a result of applying the requirements of that Subtopic has a value of zero.

815-15-55-54

Variable annuity products are investment contracts as discussed in Subtopic 944-20. Similar to variable life insurance products, policyholders direct their investment account asset mix among a variety of mutual funds composed of equities, bonds, or both, and assume the risks and rewards of investment performance. The funds are generally maintained in separate accounts by the insurance entity. Contract terms generally provide that if the policyholder dies, the greater of the account market value or a minimum death benefit guarantee will be paid. The minimum death benefit guarantee is generally limited to a return of premium plus a minimum return (such as 3 or 4 percent); this life insurance feature represents the fundamental difference from the life insurance contracts that include significant (rather than minimal) levels of life insurance. Over time, these minimum death benefit guarantees have become increasingly sophisticated. The investment account may have various payment alternatives at the end of the accumulation period. One alternative is the right to purchase a life annuity at a fixed price determined at the initiation of the contract.

815-15-55-55

Variable annuity product structures as discussed in Topic 944 are generally not subject to the scope of this Subtopic, as follows:

a
Death benefit component. Paragraph 815-10-15-53(a) excludes a death benefit from the scope of Subtopic 815-10 because the payment of the death benefit is the result of an identifiable insurable event instead of changes in an underlying. Additionally, the death benefit may meet the criteria of a market risk benefit, which is excluded from the scope of this Topic. The death benefit in this example is limited to the floor guarantee of the investment account, calculated as the premiums paid into the investment account plus a guaranteed rate of return, less the account fair value. Topic 944 remains the applicable guidance for the insurance-related accounting.
b
Investment component. The policyholder directs certain premium investments in the investment account that includes equities, bonds, or both, which are held in separate accounts that are distinct from the insurance entity's general account assets. This component is not considered a derivative instrument because of the unique attributes of traditional variable annuity contracts issued by insurance entities. Furthermore, any embedded derivatives within those investments shall not be separated from the host contract by the insurance entity because the separate account assets are already marked to fair value under Topic 944. In contrast, if the product were an equity-index-based interest annuity (rather than a traditional variable annuity), the investment component may contain an embedded derivative (the equity index-based derivative instrument) that meets all the requirements of paragraph 815-15-25-1 for separate accounting. Before concluding that the investment component contains an embedded derivative, the insurance entity should first evaluate whether the equity-index-based interest annuity contains a market risk benefit (see paragraph 944-40-25-25C).
c
Investment account surrender right at fair value. Because this right is exercised only at the fund fair value (without the insurance entity's floor guarantee) and relates to a traditional variable annuity contract issued by an insurance entity, this right is not within the scope of Subtopic 815-10.
d
Payment alternatives at the end of the accumulation period. Payment alternatives that are market risk benefits accounted for under Topic 944 on insurance are not within the scope of this Topic.

815-15-55-56

The guidance in (b) and (c) in the preceding paragraph is an exception for traditional variable annuity contracts issued by insurance entities. In determining the accounting for other seemingly similar structures, it would be inappropriate to analogize to that guidance due to the unique attributes of traditional variable annuity contracts.

815-15-55-57

Paragraph superseded by Accounting Standards Update No. 2018-12.

815-15-55-58

During the accumulation phase of a deferred annuity contract, a guarantee of a minimum interest rate to be used in computing periodic annuity payments if and when a policyholder elects to annuitize does not require separate accounting under paragraph 815-15-25-1 because the criterion in paragraph 815-15-25-1(c) is not met. The embedded option does not meet the definition of a derivative instrument because it does not meet the net settlement criteria as discussed beginning in paragraph 815-10-15-99. Settlement of the option can be achieved only by an investment of the account balance in a payout annuity contract in lieu of electing an immediate payment of the account value. If an additional provision existed whereby the policyholder could withdraw all or a portion of its account balance during the payout phase, an embedded derivative would still not exist because the economic benefit of the guaranteed minimum interest rate would be obtainable only if an entity were to maintain the annuity contract through its specified maturity date. However, the embedded option may be considered a market risk benefit (see paragraph 944-40-25-25C).

815-15-55-59

Paragraph superseded by Accounting Standards Update No. 2018-12.

815-15-55-60

Paragraph superseded by Accounting Standards Update No. 2018-12.

815-15-55-61

Paragraph superseded by Accounting Standards Update No. 2018-12.

815-15-55-62

This Subtopic defines an equity-indexed annuity as a deferred fixed annuity contract with a guaranteed minimum interest rate plus a contingent return based on some internal or external equity index, such as the Standard & Poor's S&P 500 Index. The guaranteed contract value is generally designed to meet certain regulatory requirements such that the contract holder receives no less than 90 percent of the initial deposit, compounded annually at 3 percent, which establishes a floor value for the contract. Equity-indexed annuities typically have minimal mortality risk and are therefore classified as investment contracts under Topic 944. Equity-indexed annuities often do not have specified maturity dates; therefore, the contracts remain in the deferral (accumulation) phase until the customer either surrenders the contract or elects annuitization. Customers typically can surrender the contract at any point in time, at which time they receive their account value, as specified in the contract, less any applicable surrender charges. The account value is defined in the policy as generally the greater of the policyholder's initial investment plus the equity-indexed return or a guaranteed floor amount (calculated as the policyholder's initial investment plus a specified annual percentage return).

815-15-55-63

There are two basic designs for equity-indexed annuities:

a
The periodic ratchet design, where in the annual version, the customer receives the greater of the appreciation in the equity index during a series of one-year periods (ending on each policy anniversary date) or the guaranteed minimum fixed rate of return over that period
b
The point-to-point design, where the customer receives the greater of the appreciation in the equity index during a specified period (for example, five or seven years, starting on the policy issue date) or the guaranteed minimum fixed rate of return over that period.

815-15-55-64

For many products of either design, the contract has any of the following characteristics:

a
The contract holder receives only a portion of the appreciation in the S&P 500 Index (or other index, as applicable) during the specified period (a participation rate).
b
The contract has an upper limit on the amount of appreciation that will be credited during any period (a cap rate).

815-15-55-65

For the annual ratchet design, the prospective participation and cap rates for each one-year period are often at the discretion of the issuer, and may be reset on future policy anniversary dates, subject to contractual guarantees. Flexibility on the part of the issuer to establish new cap and participation rates, coupled with uncertainty around the customer's account value (which establishes the notional amount of the option) and strike price (which is determined by the level of the index on subsequent anniversary dates) make several of the terms of the forward-starting options unknown at the annuity contract's inception. However, those flexible terms can be viewed as a bundle of options.

815-15-55-66

Therefore, holders of equity-indexed annuities that are preparing financial statements shall separate the equity-indexed return portion of the contract, apply this Subtopic, including the guidance in the following paragraph through paragraph 815-15-55-72.

815-15-55-67

Before evaluating whether an equity-indexed annuity contains an embedded derivative, an insurance entity should first evaluate whether the contract contains a market risk benefit (see paragraph 944-40-25-25C). Generally, the equity index feature represents a periodic crediting rate mechanism that affects the amounts credited to the contract holder's account balance, rather than representing a benefit in addition to the account balance that protects the contract holder from other-than-nominal capital market risk and exposes the insurance entity to other-than-nominal capital market risk. Periodic crediting rate mechanisms are required to be evaluated for possible bifurcation under this Topic. However, an equity-indexed annuity also may contain one or more market risk benefits (see paragraphs

944-40-55-29A through 55-29D

). From an insurance entity's perspective, the option component of an equity-indexed annuity that specifies a point-to-point design meets the definition of a derivative instrument and requires separate accounting under paragraph 815-15-25-1 unless a fair value election is made pursuant to paragraph 815-15-25-4. (Note that Section 815-15-25 allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. However, Section 815-15-25 does not apply to hybrid financial instruments that are described in paragraph 825-10-50-8, which include insurance contracts as discussed in Subtopic 944-20, other than financial guarantees and investment contracts.)

815-15-55-68

This guidance also applies to the policyholder because the policyholder does not qualify for a scope exclusion.

815-15-55-69

For the periodic ratchet design product, the insurance entity has committed to issue a series of options on the index over the duration of the contract. All of those forward-starting options meet the definition of a derivative instrument and require separate accounting under paragraph 815-15-25-1 from the perspective of the insurance entity unless a fair value election is made pursuant to paragraph 815-15-25-4. Paragraph 815-15-25-7 requires that the embedded feature with multiple components be separately accounted for as one compound embedded derivative.

815-15-55-70

In valuing those options, there are three main components to be considered:

a
Future S&P 500 Index (or other index, as applicable) values will need to be estimated to determine both the future notional amounts at each ratchet date and the future strike prices of the future forward starting options.
b
Future annual cap and participation rates, which are often at the discretion of the contract issuer, subject to contractually specified minimums and maximums, will need to be estimated.
c
Noneconomic factors related to policyholder-driven developments such as policy surrenders or mortality.

815-15-55-71

Given the three components, the forward starting options should be valued using the expected future terms (that is, index values and cap and participation rates), but in no event should the value be less than the minimum amounts contractually agreed on in the contract. Expected terms represent management's estimates of cap and participation rates, rather than contractually guaranteed amounts. The estimated value reflects the notion that the contract provides for a level of equity-indexed return that can be estimated even when considering the issuer's options to adjust the policyholder's participation and cap rates. In subsequent periods when the terms of the forward-starting options become known, the actual terms should be substituted for the expected terms for purposes of valuation.

815-15-55-72

This guidance also applies to the policyholder (provided it prepares GAAP-based financial statements) because the contracts do not qualify for a scope exception.

815-15-55-73

Equity-indexed life insurance contracts combine term life insurance coverage with an investment feature, similar to universal life contracts. Death benefit amounts are based on the amount selected by the policyholder plus the account value. Charges for the cost of insurance and administrative costs are assessed periodically against the account. The policyholder's account value, maintained in the insurance entity's general account (not a separate account), is based on the cumulative deposits credited with positive returns based on the S&P 500 Index or some other equity index. An essential component of the contract is that the cash surrender value is also linked to the index. Accordingly, the policy's cash surrender value is also linked to an equity index. The death benefit amount may also be dependent on the cumulative return on the index.

815-15-55-74

Equity-indexed life insurance contracts are accounted for as universal life insurance contracts under Topic 944. For those contracts, the customer's account value (the investment component of a universal life contract) is credited with a return indexed to an equity index (for example, the S&P 500) rather than an interest rate established by the insurance entity, as is done with typical universal life contracts. The existence of the death benefit provision does not exclude the entire equity-indexed life insurance contract from being subject to Subtopic 815-10 for either the issuer or the policyholder because the policyholder can obtain an equity-linked return by exercising the surrender option before death. Before evaluating whether the equity-indexed life insurance contract contains an embedded derivative, an insurance entity should first evaluate whether the contract contains a market risk benefit (see paragraph 944-40-25-25C).

815-15-55-75

If the investment component of the equity-indexed life insurance contract does not contain a market risk benefit, then the investment component of the equity-indexed life insurance contract would contain an embedded derivative (the equity index-based derivative) that meets all of the requirements of paragraph 815-15-25-1 for separate accounting. (Note that Section 815-15-25 allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. However, Section 815-15-25 does not apply to hybrid instruments that are described in paragraph 825-10-50-8, which include insurance contracts as discussed in Subtopic 944-20, other than financial guarantees and investment contracts.)

815-15-55-76

In contrast, if the contract contained an equity-indexed death benefit component that was over and above the cash surrender value that is payable to the policyholder upon surrender of the policy, that death benefit component would not meet the criterion in paragraph 815-15-25-1(c) for separate accounting. As a separate instrument, that death benefit component would not be a derivative instrument subject to the requirements of Subtopic 815-10 due to the paragraph 815-10-15-53 exclusion for benefits payable only upon death, as illustrated in paragraphs

815-15-55-55 through 55-56

815-15-55-76A

The following steps specify how an issuer shall apply the guidance on accounting for embedded derivatives in this Subtopic to a convertible debt instrument within the scope of Subtopic 470-20.

a
Step 1. Identify embedded features, including the embedded conversion option that must be evaluated under Subtopic 815-15.
b
Step 2. Apply the guidance in Subtopic 815-15 to determine whether any of the embedded features identified in Step 1 must be separately accounted for as derivative instruments.
c
Step 3. Apply the guidance in Subtopic 470-20 to account for the convertible debt instrument (including the embedded conversion option and any other embedded features, which are not separately accounted for as a derivative instrument in Step 2) as a liability.
d
Step 4. If one or more embedded features are required to be separately accounted for as a derivative instrument based on the analysis performed in Step 2, that embedded derivative shall be separated from the host contract in accordance with the guidance in this Subtopic.

815-15-55-76B

An issuer should follow steps similar to those in paragraph 815-15-55-76A to apply the accounting guidance for embedded derivatives in this Subtopic to convertible preferred stock within the scope of Subtopic 505-10, except that in Step 3 the convertible preferred stock (including the conversion option and any other embedded features, which are not separately accounted for as a derivative instrument in Step 2) should be accounted for as equity in accordance with Subtopic 505-10.

From the investor's perspective, the purchase of common stock with an embedded purchased put option that requires physical settlement is a hybrid instrument that shall be evaluated to determine whether it has an embedded derivative that shall be accounted for separately. The embedded purchased put option shall be separated from the equity host because the common stock and the embedded put option are not clearly and closely related (see paragraph 815-15-25-20). For guidance related to an issuer's accounting, see paragraph 815-10-15-76.

Illustrations

815-15-55-83

The following Cases illustrate the application of paragraph 815-15-15-10(b)(1):

a
Guarantor not a substantial party to a two-party lease (Case A)
b
Requisite knowledge, resources, and technology (Case B)
c
Highly inflationary environment (Case C).

815-15-55-84

A U.S. parent entity for which the U.S. dollar is the functional currency has a French subsidiary with a Euro functional currency. The subsidiary enters into a lease with a Canadian entity for which the Canadian dollar is the functional currency that requires lease payments denominated in U.S. dollars. The parent entity guarantees the lease.

815-15-55-85

The exception in paragraph 815-15-15-10(b)(1) does not apply to the contract. The substantial parties to a lease contract are the lessor and the lessee; a third-party guarantor is not a substantial party to a two-party lease, even if it is a related party (such as a parent entity). Thus, the functional currency of a guarantor is not relevant to the application of that paragraph.

815-15-55-86

The requirement in paragraph 815-15-15-10(b)(1) that the payments be denominated in the functional currency of at least one substantial party to the transaction ensures that the foreign currency is integral to the arrangement and thus considered to be clearly and closely related to the terms of the lease.

815-15-55-87

A U.S.-based construction entity (the Parent) pursues business in a foreign country on a major construction contract. The Parent has an operating subsidiary (the Subsidiary) in that foreign country. The Subsidiary's functional currency is determined to be the local currency (because of business activities unrelated to the construction contract), which is also the functional currency of the customer under the contract. The Parent's functional currency is the U.S. dollar.

815-15-55-88

Primarily for tax and political reasons, the Parent causes its Subsidiary to enter into a contract with the customer (that is, the contract is legally between the Subsidiary and the customer). The contract requires payments by the customer in U.S. dollars. The payments are in U.S. dollars to facilitate the compensation of the Parent for its significant involvement in and management of the contract entered into by the Subsidiary.

815-15-55-89

The Subsidiary, by itself, does not possess the requisite financial, human, and other resources, technology, and knowledge to execute the construction contract on its own. The Parent provides the majority of the resources required under the contract, including direct involvement in negotiating the terms of the contract, managing and executing the contract throughout its duration, and maintaining all contract supporting functions, such as legal, tax, insurance, and risk management. Because it is controlled by the Parent, the Subsidiary does not have a choice of subcontractor for these resources and services and will always integrate the Parent into all phases of the contract. Without the Parent, the Subsidiary and the customer would probably never have entered into the construction contract because the Subsidiary could not perform under this contract without the help of the Parent.

815-15-55-90

In this Case, the Parent is a substantial party to the construction contract entered into by the Subsidiary for the purposes of applying paragraph 815-15-15-10(b)(1) because the Parent will be providing the majority of resources required under the contract on behalf of the Subsidiary, which is the legal party to the contract.

815-15-55-91

The following Cases illustrate the application of the scope exception in paragraph 815-15-15-10:

a
The contractual payments are denominated in a currency that, while not the functional currency, is used as if it were the functional currency due to a highly inflationary economy (Case C1).
b
The economy of the primary economic environment ceases to be highly inflationary after the inception of the contract (Case C2).

815-15-55-92

Cases C1 and C2 share the following assumptions. A U.S. parent entity for which the U.S. dollar (USD) is both the functional currency and the reporting currency has a Venezuelan subsidiary. The subsidiary's sales, expenses, and financing are primarily denominated in the Mexican peso (MXN), and therefore the subsidiary considers MXN to be its functional currency as required by Topic 830. However, assume that the economy in Mexico is highly inflationary, and therefore that Topic requires that the parent entity's reporting currency (that is, USD) be used as if it were the subsidiary's functional currency. The subsidiary enters into a lease with a Canadian entity for property in Venezuela that requires the subsidiary to make lease payments in USD. Further, assume that the Canadian entity's functional currency is the Canadian dollar (CAD). The Venezuelan subsidiary's local currency is VEB (the Venezuelan bolivar).

815-15-55-93

The exception in paragraph 815-15-15-10 applies to contract because the subsidiary uses USD as if it were the functional currency. The conclusion is not affected by the fact that USD is not the currency of the primary economic environment in which either the Venezuelan subsidiary or the Canadian lessor operates (that is, USD is not the functional currency of either party to the lease). The forward contract to deliver USD embedded in the lease contract should not be bifurcated from the lease host. The exception in paragraph 815-15-15-10 would apply to the lease contract in this Example if the payments under that contract were denominated in any of the following four currencies: USD, MXN, VEB, or CAD. The exception applies to both of the substantial parties to the contract, the lessor and the lessee.

815-15-55-94

Assume that, during the term of the property lease, the Mexican economy ceases to be highly inflationary. Therefore, the Venezuelan subsidiary's financial statements cease to be remeasured as if USD were the functional currency and, instead, those financial statements are remeasured using the subsidiary's functional currency, MXN.

815-15-55-95

When the lease was entered into, the subsidiary used USD as if it were the functional currency; therefore, the foreign currency embedded derivative would have qualified for the exception in paragraph 815-15-15-10 for both the lessor and the lessee. The fact that the subsidiary subsequently ceased using USD as if it were the functional currency and, instead, now uses MXN (which was outside the control of management of the entity because it is contingent upon a change in the Mexican economy) does not affect the application of the exception because the subsidiary qualified for the exception at the inception of the contract. However, if the subsidiary would enter into an extension of the lease or a new lease that required payments in USD, the exception would not apply because at the time the new or extended lease was entered into, the subsidiary no longer used USD as if it were the functional currency.

815-15-55-96

This Example illustrates the application of the phrase routinely denominated in international commerce in paragraph 815-15-15-10(b)(2).

815-15-55-97

A real estate lease negotiated privately between entities involved in international commerce in certain South American economies would routinely require U.S. dollar (USD) payments. Real estate leases negotiated privately between entities involved in international commerce in European economies would routinely not require USD payments. The lessee is a Canadian entity that uses the Canadian dollar (CAD) as its functional currency. The lessor is a Venezuelan entity whose functional currency is the Mexican peso (MXN). The lease payments are denominated in USD.

815-15-55-98

Because real estate leases around the world are not routinely denominated in USD, the leasing transaction would not qualify for the exception in paragraph 815-15-15-10(b)(2).

815-15-55-99

This Example illustrates the application of the clearly and closely related criterion in paragraph 815-15-25-1(a). Two entities enter into a long-term service contract whereby Entity A agrees to provide a service to Entity B at market rates over a three-year period. Entity B forecasts it will pay DKK (the Danish kroner) 1,000 to Entity A at the end of the 3-year period for all services rendered under the contract. Entity A's functional currency is DKK and Entity B's is the U.S. dollar (USD). In addition to providing the terms under which the service will be provided, the contract includes a foreign currency exchange provision. The provision requires that over the term of the contract, Entity B will pay or receive an amount equal to the fluctuation in the DKK/USD exchange rate applied to a notional amount of DKK 100,000 (that is, if USD appreciates against DKK, Entity B will pay the appreciation, and if USD depreciates against DKK, Entity B will receive the depreciation). The host contract is not a derivative instrument and will not be recorded in the financial statements at fair value.

815-15-55-100

The foreign currency derivative embedded in the long-term service contract should be separated from the host long-term service contract and considered a derivative instrument under paragraph 815-15-25-1. (Note that Section 815-15-25 does not apply to hybrid instruments that are not financial instruments, such as contracts that require the delivery of services.) Because the contract is leveraged by requiring the computation of the payment based on a DKK 100,000 notional amount, the contract is a hybrid instrument that contains an embedded derivative—a foreign currency swap with a notional amount of DKK 99,000. That embedded derivative is not clearly and closely related to the host contract and under paragraph 815-15-25-1 shall be recorded separately from the DKK 1,000 contract. Either party to the contract can designate the bifurcated foreign currency derivative instrument as a hedging instrument pursuant to Subtopic 815-20 if applicable qualifying criteria are met.

815-15-55-101

The following Cases illustrate the application of paragraph 815-15-25-46:

a
Credit-linked note (Case A)
b
Reinsurer's receivable arising from a modified coinsurance arrangement (Case B).

815-15-55-102

In both of these Cases, the embedded derivative generally will require bifurcation. However, the criteria in paragraph 815-15-25-1(b) through (c) shall be considered before concluding that the embedded derivative should be bifurcated and accounted for separately. The nature of the embedded derivative and the host contract in both Cases should be determined based on the facts and circumstances of the individual contract.

815-15-55-103

Entity A issues to an investor a fixed-rate, 10-year, $10 million credit-linked note that provides for periodic interest payments and the repayment of principal at maturity. However, upon default of a specified reference security (an Entity X subordinated debt obligation) the redemption value of the note may be zero or there may be some claim to the recovery value of the reference security (depending on the terms of the specific arrangement). Generally, the term reference security refers to the security whose credit rating or default determines the cash flows under a credit derivative. Usually, the terms of credit-linked notes explicitly reference Committee on Uniform Security Identification Procedures (CUSIP) numbers of securities in the marketplace. In an event of default of the specified reference security, there is no recourse to the general credit of the obligor (Entity A). In exchange for accepting the default risk of the reference security, the note entitles the investor to an enhanced yield. The transaction results in the investor selling credit protection and Entity A buying credit protection.

815-15-55-104

The credit-linked note includes an embedded credit derivative. The credit risk exposure of the reference security (Entity X) and the risk exposure arising from the creditworthiness of the obligor (Entity A) are not clearly and closely related. Thus, the economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the debt host contract and, accordingly, the criterion in paragraph 815-15-25-1(a) is met.

815-15-55-105

Paragraph 815-15-25-6 explains that the fair value election for hybrid financial instruments that otherwise would require bifurcation does not apply to hybrid financial instruments that are described in paragraph 825-10-50-8, which include insurance contracts as discussed in Section 944-20-15, other than financial guarantees and investment contracts.

815-15-55-106

Consideration should be given to whether the embedded derivative could possibly not be subject to this Topic as a financial guarantee under paragraph 815-10-15-58 and, in that circumstance, the embedded derivative would not warrant bifurcation.

815-15-55-107

Reinsurance Entity B enters into a modified coinsurance arrangement (also referred to as a modco arrangement), which is a reinsurance arrangement in which funds are withheld by the ceding insurer, thereby creating an obligation for the ceding entity to pay the reinsurer at a later date. Concurrently, the reinsurer (Entity B) recognizes a funds-withheld receivable from the ceding insurer as well as a liability representing reserves for the insurance coverage assumed under the modco arrangement. (The amount of Entity B's receivable is the ceding entity's statutory reserve, whereas the amount of Entity B's liability is the reserve under GAAP.) The terms of the ceding entity's payable (and Entity B's funds-withheld receivable) provide for the future payment of a principal amount plus a return (that may be negative) that is based on a specified proportion of the ceding entity's return on either its general account assets or a specified block of those assets (such as a specific portfolio of its investment securities). That portfolio is typically composed primarily of fixed-rate debt securities.

815-15-55-108

With respect to the modified coinsurance arrangement, the ceding entity's funds-withheld payable and Entity B's funds-withheld receivable include an embedded derivative that is not clearly and closely related to the host contract. The yield on the payable and receivable in the host contract in this Case is based on a specified proportion of the ceding entity's return on either its general account assets or a specified block of those assets (such as a specific portfolio of the ceding entity's investment securities). The risk exposure of the ceding entity's return on its general account assets or its securities portfolio is not clearly and closely related to the risk exposure arising from the overall creditworthiness of the ceding entity, which is also affected by other factors. Consequently, the economic characteristics and risks of the embedded derivative feature are not clearly and closely related to the economic characteristics and risks of the host contract and, accordingly, the criterion in paragraph 815-15-25-1(a) is met. This analysis applies whether the host contract is determined to be a debt host or an insurance contract. For example, if the host contract is determined to be the modified coinsurance arrangement (including the funds-withheld receivable-payable but excluding the embedded derivative), the economic characteristics and risks of the embedded derivative feature are not clearly and closely related to the economic characteristics and risks of the host contract and, accordingly, the criterion in that paragraph is met.

815-15-55-109

The other criteria in paragraph 815-15-25-1 generally would be met, thereby requiring that the embedded derivative be bifurcated and accounted for separately.

815-15-55-110

This Example illustrates the application of the clearly and closely related criterion in paragraph 815-15-25-1(a). A reporting entity issues $100,000 of mandatorily redeemable preferred stock whose preferred dividends are payable in cash but that requires redemption at the end of 1 year for a payment of 312 ounces of gold. Alternatively, the reporting entity issues $100,000 of mandatorily redeemable preferred stock whose redemption at the end of 1 year is payable only in a fixed amount of a specified foreign currency. Topic 480 requires that mandatorily redeemable financial instruments in the form of shares, as defined in that Subtopic, be classified as liabilities, and not as temporary equity (which had been done previously). Consequently, this guidance does not address the application of paragraph 815-10-15-74(a).

815-15-55-111

The mandatorily redeemable preferred stock payable in gold contains an embedded derivative whose underlying is the price of gold. That embedded derivative should be separated from the host contract and accounted for as a derivative instrument because the embedded derivative is not clearly and closely related to the host contract.

815-15-55-112

Mandatorily redeemable preferred stock whose periodic preferred dividend payments, redemption payment, or both are payable only in a stipulated amount of a specified foreign currency contain no embedded foreign currency derivative that warrants separate accounting under this Subtopic. Instead, the reporting entity shall apply the provisions of Topic 830 to the foreign-currency-denominated mandatorily redeemable preferred stock.

815-15-55-113

In contrast, if the holder of the mandatorily redeemable preferred stock had the choice of receiving, or the issuer had the choice of making, the redemption payment, the dividend payments, or both in either a stipulated amount of U.S. dollars or a stipulated amount of a specified currency, then that instrument contains an embedded foreign currency option that is subject to this Subtopic. Because the reporting entity has the option to make payments in U.S. dollars or in a specified foreign currency, the provisions of paragraph 815-15-15-10 are not relevant to that instrument. That embedded foreign currency option should be separated from the host contract and accounted for as a derivative instrument because the embedded foreign currency option is not clearly and closely related to issuing preferred stock unless a fair value election is made pursuant to paragraph 815-15-25-4.

815-15-55-114

This Example illustrates the application of the clearly and closely related criterion as discussed in paragraphs 815-15-25-1(a) and 815-15-25-19. A manufacturer enters into a long-term contract to purchase a specified quantity of certain raw materials from a supplier. Under the contract, the supplier will provide the manufacturer with the materials at the then-current list price but within a specified range. For example, the purchase price may not exceed a cap of $120 per ton or fall below a floor of $100 per ton, and the current list price at inception of the contract is $110 per ton. The purchase contract in its entirety does not meet the definition of a derivative instrument due to the absence of a net settlement characteristic (that is, the contract requires delivery of a raw material that is not readily convertible to cash). In addition, the purchase contract is not measured at fair value under other applicable GAAP.

815-15-55-115

From the manufacturer's perspective, the embedded derivatives contained in the purchase contract are 2 options: a purchased call option with a strike price of $120 per ton and a written put option with a strike price of $100 per ton. Those options would meet the definition of a derivative instrument under Subtopic 815-10 if they were freestanding because they have a notional amount, have an underlying (the price per ton), require a small or no initial net investment, and can be net settled. Those options have the characteristic of net settlement under paragraph 815-10-15-100 because they represent an adjustment (that is, either a premium or rebate) of the current list price in an amount equal to the difference between that current list price and the applicable strike amount (of either $120 per ton or $100 per ton). (Paragraphs

815-10-15-119 through 15-120

do not apply to the options because they have no provision for delivery.) The host contract can be considered a purchase contract that requires delivery of the raw materials at a price equal to the current list price.

815-15-55-116

Although the example purchase contract economically contains embedded derivatives, those embedded derivatives should not be accounted for separately because they are clearly and closely related to the host contract.

815-15-55-117

This Example illustrates the application of the clearly and closely related criterion in paragraph 815-15-25-1(a)to the determination of what is the host contract and what is the embedded derivative composing the illustrative hybrid instrument. This Example has the following assumptions:

a
An entity (Entity A) issues a 5-year debt instrument with a principal amount of $1,000,000 indexed to the stock of an unrelated publicly traded entity (Entity B).
b
At maturity, the holder of the instrument will receive the principal amount plus any appreciation or minus any depreciation in the fair value of 10,000 shares of Entity B, with changes in fair value measured from the issuance date of the debt instrument.
c
No separate interest payments are made.
d
The market price of Entity B shares to which the debt instrument is indexed is $100 per share at the issuance date.

815-15-55-118

The instrument is not itself a derivative instrument because it requires an initial net investment equal to the notional amount. The host contract is a debt instrument because the instrument has a stated maturity and because the holder has none of the rights of a shareholder, such as the ability to vote the shares and receive distributions to shareholders. The embedded derivative is an equity-based derivative that has as its underlying the fair value of the stock of Entity B. As a result of the host instrument being a debt instrument and the embedded derivative having an equity-based return, the embedded derivative is not clearly and closely related to the host contract and must be separated from the host contract and accounted for as a derivative by both the issuer and the holder of the hybrid instrument. (Paragraph 815-15-25-4 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 Topic 815 hedging relationship.)

815-15-55-119

This Example illustrates the application of the clearly and closely related criterion in paragraph 815-15-25-1(a). Even though an overall hybrid instrument that provides for repayment of principal may include a return based on the market price (the underlying as defined) of XYZ Corporation common stock, the host contract does not involve any existing or potential residual interest rights (that is, rights of ownership) and thus would not be an equity instrument. The host contract would instead be considered a debt instrument, and the embedded derivative that incorporates the equity-based return would not be clearly and closely related to the host contract.

815-15-55-120

This Example illustrates the application of the clearly and closely related criterion in paragraph 815-15-25-1(a) to a market value annuity accounted for as an investment contract under Topic 944.

815-15-55-121

As an example of how the market-adjusted value is calculated at any period end, the formula typically takes the contractual guaranteed amount payable at the end of the specified term, including the applicable guaranteed interest, and discounts that future cash flow to its present value using rates currently being offered for new market value annuity purchases with terms equal to the remaining term to maturity of the existing market value annuity. As a result, the market value adjustment may be positive or negative, depending on market interest rates at each period end. In a rising interest rate environment, the market adjustment may be such that less than substantially all principal is recovered upon surrender.

815-15-55-122

Assume all of the following terms of an example annuity with a fixed return if held for a specified period or market-adjusted value if surrendered early:

a
Single premium deposit: $100,000 on December 31, 1998
b
Maturity date: December 31, 2007 (9-year term)
c
Guaranteed fixed rate: 7%
d
Fixed maturity value: $183,846 ($100,000 at 7% compounded for 9 years)
e
Market value adjustment formula: discount future fixed maturity value to present value at surrender date using currently offered market value annuity rate for the period of time left until maturity.

815-15-55-123

Assume the following values at December 31, 1999.

12/31/99 Valuation Date 5% 9% (1) Fixed rate account value @7% " $107,000 " " $107,000 " (2) Market adjusted value " 124,434 " " 92,266 " (3) Market value adjustment " $17,434 " " $(14,734)"

815-15-55-124

Because the criteria in paragraphs 815-15-25-26 and

815-15-25-41 through 25-43

are not met, the embedded derivative (prepayment option) is clearly and closely related to the host debt contract.

815-15-55-125

There is no substantial premium or discount present in these contracts at inception, and the put option is exercisable at any time by the contract holder (that is, the put option is not contingently exercisable). Because the investor always has the option to hold the market value annuity to maturity and receive the fixed rate and the insurance entity cannot force the investor to surrender, the condition in paragraph 815-15-25-26(a) would not be met (that is, the insurance entity does not have the contractual right to demand surrender and put the investor in a situation of not recovering substantially all of its initial recorded investment).

815-15-55-126

The condition in paragraph 815-15-25-26(b) also would not be met in a typical market value annuity, because there is no leverage feature that would result in twice the initial and current market rate of return.

815-15-55-127

The prepayment option enables the holder simply to cash out of the instrument at fair value at the surrender date. The prepayment option provides only liquidity to the holder. The holder receives only the market-adjusted value, which is equal to the fair value of the investment contract at the surrender date. As such, the prepayment option (the embedded derivative) has a fair value of zero at all times.

815-15-55-128

The following Cases illustrate the application of paragraph 815-15-25-26(a):

a
Note A (Case A)
b
Note B (Case B)
c
Note C (Case C).

815-15-55-129

The accompanying analysis does not address the application of the condition in paragraph 815-15-25-26(b).

815-15-55-130

If an investor in a 10-year note has the contingent option at the end of Year 2 to put it back to the issuer at its then fair value (based on its original 10-year term), the condition in paragraph 815-15-25-26(a) would not be met even though the note's fair value could have declined so much that, by exercising the option, the investor ends up not recovering substantially all of its initial recorded investment. See paragraph 815-15-25-29.

815-15-55-131

An investor purchased from an A-rated issuer for $10 million a structured note with a $10 million principal, a 9.5 percent interest coupon, and a term of 10 years at a time when the current market rate for 10-year A-rated debt is 7 percent. Assume that the terms of the note require that, at the beginning of the third year of its term, the principal on the note be reduced to $7.1 million and the coupon interest rate be reduced to zero for the remaining term to maturity if interest rates for A-rated debt have increased to at least 8 percent by that date. That structured note would meet the condition in paragraph 815-15-25-26(a) for both the issuer and the investor because the investor could be forced to accept settlement that causes the investor not to recover substantially all of its initial recorded investment. That is, if increases in the interest rate for A-rated debt trigger the modification of terms, the investor would receive only $9 million, comprising $1.9 million in interest payments for the first 2 years and $7.1 million in principal repayment, thus not recovering substantially all of its $10 million initial net investment.

815-15-55-132

The investor purchases for $10,000,000 a structured note with a face amount of $10,000,000, a coupon of 8.9 percent, and a term of 10 years. The current market rate for 10-year debt is 7 percent given the A credit quality of the issuer. The terms of the structured note require that if the interest rate for A-rated debt has increased to at least 10 percent at the end of 2 years, the coupon on the note be reduced to zero, and the investor purchase from the issuer for $10,000,000 an additional note with a face amount of $10,000,000, a zero coupon, and a term of 3.5 years.

815-15-55-133

The structured note contains an embedded derivative that shall be accounted for separately unless a fair value election is made pursuant to paragraph 815-15-25-4.

815-15-55-134

The requirement that, if interest rates increase and the embedded derivative is triggered, the investor purchase the second $10,000,000 note for an amount in excess of its fair value (which is about $7,100,000 based on a 10 percent interest rate) generates a result that is economically equivalent to requiring the investor to make a cash payment to the issuer for the amount of the excess. As a result, the cash flows on the original structured note and the excess purchase price on the second note shall be considered in concert. The cash inflows ($10,000,000 principal and $1,780,000 interest) that will be received by the investor on the original note shall be reduced by the amount ($2,900,000) by which the purchase price of the second note is in excess of its fair value, resulting in a net cash inflow ($8,880,000) that is not substantially all of the investor's initial net investment on the original note.

815-15-55-135

As demonstrated by this Case, if an embedded derivative requires an asset to be purchased for an amount that exceeds its fair value, the amount of the excess—and not the cash flows related to the purchased asset—shall be considered when analyzing whether the hybrid instrument can contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment under paragraph 815-15-25-26(a). Whether that purchased asset is a financial asset or a nonfinancial asset (such as gold) is not relevant to the treatment of the excess purchase price. It is noted that requiring the investor to make a cash payment to the issuer is also economically equivalent to reducing the principal on the note.

815-15-55-136

The note described could have been structured to include terms requiring that the principal of the note be substantially reduced and the coupon reduced to zero if the interest rate for A-rated debt increased to at least 10 percent at the end of 2 years. That alternative structure would clearly have required that the embedded derivative be accounted for separately, because that embedded derivative's existence would have resulted in the possibility that the hybrid instrument could contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment.

815-15-55-137

The following Cases illustrate the application of the guidance beginning in paragraph 815-15-25-26(b) to specific securitized interests in prepayable financial assets:

a
Securitized pool of guaranteed single-class mortgage pass-through securities (Case A)
b
Securitized pool of guaranteed single-class mortgage pass-through securities (Case B)
c
Inverse floater collateralized mortgage obligation (Case C).

815-15-55-138

The Cases provide no discussion of the requirements of paragraphs 815-15-25-1 and 815-15-25-26(a). However, an analysis of those paragraphs would be required to determine whether the instruments meet the criterion in paragraph 815-15-25-26(b). The analysis of the Cases considers only paragraph 815-15-25-26(b).

815-15-55-139

The following Cases illustrate application of the guidance in paragraph 815-15-25-26(b) to a guaranteed single-class mortgage pass-through security:

a
Guaranteed single-class mortgage pass-through security (Case A1)
b
Securitization trust includes a freestanding derivative instrument (Case A2).

815-15-55-140

Cases A1 and A2 share all of the following assumptions:

a
A fixed-rate guaranteed single-class mortgage pass-through security is issued.
b
Both the interest and principal payments are guaranteed by a third party for a fixed market-based guarantee fee, and a servicer receives a market-based servicing fee that is expected to be more than adequate compensation.
c
Both the guarantee fee and the servicing fee have priority over the payments to the investors.
d
The investor does not have the right to accelerate the settlement of the securitized interest.

815-15-55-141

Under the security, the net cash flows received on the underlying fixed-rate, prepayable, single-family mortgage loans are proportionately passed through to the investors.

815-15-55-142

Paragraph 815-15-25-26(b) does not apply to the guaranteed single-class mortgage pass-through security described in the common assumptions and the preceding paragraph. While the priority of the payments to the guarantor and servicer reallocates the cash flows, the example security meets the two criteria in paragraph 815-15-25-26(b).

815-15-55-143

Under the security, the underlying prepayable single-family mortgage loans have a variable interest rate. The securitization trust also holds an interest rate swap that is designed to perfectly swap the variable interest rate assets to a fixed interest rate to match the payments on the fixed-rate guaranteed single-class mortgage pass-through security.

815-15-55-144

Paragraph 815-15-25-26(b) is not applicable to the guaranteed single-class mortgage pass-through security. Because the addition of the freestanding derivative instrument (the interest rate swap) does not create an embedded derivative that requires bifurcation in the guaranteed single-class mortgage pass-through security itself, the example security meets the two criteria in that paragraph. However, if the notional amounts of the securitized loans and the interest rate swap do not match, the fixed-rate securitized interest would have to be evaluated for an embedded derivative because the financial instruments held by the entity might not provide the necessary cash flows.

815-15-55-145

The following Cases illustrate application of paragraph 815-15-25-26(b) to an interest in a securitized pool of guaranteed single-class mortgage pass-through securities:

a
Sequential-pay collateralized mortgage obligation (Case B1)
b
Planned-amortization-class and companion collateralized mortgage obligation (Case B2)
c
Interest-only strip and principal-only strip (Case B3).

815-15-55-146

Cases B1, B2, and B3 share the assumption that an entity securitizes a pool of guaranteed single-class mortgage pass-through securities (each identical to those described in the common assumptions in Case A).

815-15-55-147

This Case assumes that the principal payments received, including prepayments of principal, on the underlying collateral are not allocated proportionately to all investors (bond holders). Three classes of securities are issued, Class A, Class B, and Class C, which mature sequentially. All three classes participate in interest payments from the underlying collateral, but, initially, only Class A receives principal payments. Class A receives all principal payments, including prepayments of principal, until it is retired. Next, all principal payments are paid to Class B until it is retired, and so on. Additionally, the investor does not have the right to accelerate the settlement of the securitized interest.

815-15-55-148

The analysis of the bonds requires the holder to assess the securitized interest in accordance with the criterion in paragraph 815-15-25-33(b). To determine whether the individual bond classes contain an embedded derivative that requires bifurcation, the investor would have to understand the nature and amount of assets, liabilities, and other financial instruments that compose the entire securitization transaction. The holder should obtain sufficient information about the payoff structure and the payment priority of the interest to determine whether an embedded derivative that requires bifurcation exists. Because the securitized interests (assumed to be identical to those described in Case A) included in the resecuritization do not contain any embedded derivatives and there have been no other changes in the cash flows that create other embedded derivatives that require bifurcation, the criterion in paragraph 815-15-25-33(b) is met.

815-15-55-149

Paragraph 815-15-25-26(b) is not applicable to any of the bond classes in the sequential-pay collateralized mortgage obligation. While the prepayment risk in the underlying financial assets is reallocated through the securitization process, concentrating prepayment risk in certain bond classes, all three classes in the Case meet the two criteria in paragraph 815-15-25-33.

815-15-55-150

Case B assumes that the principal payments received, including prepayments of principal, on the underlying collateral are not allocated proportionately to all investors (bond holders). Two classes of securities are issued, a planned-amortization-class bond and a companion bond. The planned-amortization-class bond is designed to reduce the prepayment risk to investors by transferring prepayment risk to the companion bond. The planned-amortization-class bond offers a fixed principal repayment schedule that will be met if prepayment on the underlying collateral is within a specified range. Additionally, the investor does not have the right to accelerate the settlement of the securitized interest.

815-15-55-151

815-15-55-152

Paragraph 815-15-25-26(b) is not applicable to either the planned-amortization-class or the companion collateralized mortgage obligation. While the prepayment risk in the underlying prepayable financial assets is reallocated through the securitization process, concentrating prepayment risk in the companion bond, the example securities meet the two criteria in paragraph 815-15-25-33.

815-15-55-153

An interest-only strip and principal-only strip are created by separating the net interest cash flows from the principal cash flows received on a pool of guaranteed single-class mortgage pass-through securities (identical to those described in Case A). The interest cash flows form one bond, which is the interest-only strip. The principal cash flows form the second bond, which is the principal-only strip. Additionally, the investor does not have the right to accelerate the settlement of the securitized interest.

815-15-55-154

As a result of the guarantee fee and the servicing fee in excess of adequate compensation in the underlying guaranteed single-class mortgage pass-through securities, neither the interest-only strip nor the principal-only strip qualifies for the scope exception in paragraphs

815-10-15-72 through 15-73

815-15-55-155

The analysis of the interest-only and principal-only strip requires the holder to assess the securitized interest in accordance with the criterion in paragraph 815-15-25-33(b). To determine whether the individual bond classes contain an embedded derivative that requires bifurcation, the investor would have to understand the nature and amount of assets, liabilities, and other financial instruments that compose the entire securitization transaction. The holder should obtain sufficient information about the payoff structure and the payment priority of the interest to determine whether an embedded derivative that requires bifurcation exists. Because the securitized interests (assumed to be identical to those described in Case A) included in the resecuritization do not contain any embedded derivatives and there have been no other changes in the cash flows that create other embedded derivatives that require bifurcation, the criterion in paragraph 815-15-25-33(b) is met.

815-15-55-156

Paragraph 815-15-25-26(b) is not applicable to either the interest-only strip or the principal-only strip. While the prepayment risk in the underlying prepayable financial assets is reallocated through the securitization process, concentrating prepayment risk in certain bond classes, both the interest-only strip and principal-only strip in the example meet the two criteria in paragraph 815-15-25-33.

815-15-55-157

A collateralized mortgage obligation is issued with a coupon that fluctuates inversely with a referenced rate. The underlying securitized financial assets are fixed-rate, prepayable, single-family mortgage loans. Two classes of securitized interests are issued, one with a coupon based on a referenced rate (for example, the London Interbank Offered Rate [LIBOR]) and the second with a coupon that fluctuates inversely with that same referenced rate (the inverse floater collateralized mortgage obligation). Cash flows received on the underlying collateral are first used to pay a servicer a market-based servicing fee that is expected to be more than adequate compensation. Additionally, the investor does not have the right to accelerate the settlement of the securitized interest.

815-15-55-158

Paragraph 815-15-25-26(b) would be applicable to the inverse floater. When assessing the conditions in that paragraph, the holder shall consider the effect of prepayment risk. Therefore, the holder may identify both an embedded derivative related to the prepayment risk and an embedded derivative related to the inverse interest rate risk, which would be combined and recorded as one instrument.

815-15-55-159

While the inverse floater collateralized mortgage obligation meets the criterion in paragraph 815-15-25-33(a), the fact that the coupon rate fluctuates inversely with the referenced rate results in the instrument failing the criterion in paragraph 815-15-25-33(b). The inverse floater contains an embedded interest rate derivative that requires bifurcation, and that embedded interest rate derivative does not result solely from the embedded call options in the underlying financial assets. Said another way, the inverse floater meets the conditions of paragraph 815-15-25-26(b) without consideration of the prepayment risk in the underlying mortgage loans.

815-15-55-160

This Example illustrates the application of paragraph 815-15-30-4 and assumes that the illustrative non-option embedded derivative is a plain-vanilla forward contract with symmetrical risk exposure and that the hybrid instrument was newly entered into by the parties to the contract. Assume that the hybrid instrument is not a derivative instrument in its entirety.

815-15-55-161

Entity A plans to advance Entity X $900 for 1 year at a 6 percent interest rate and concurrently enter into an equity-based derivative instrument in which it will receive any increase or pay any decrease in the current market price ($200) of XYZ Corporation's common stock. Those two transactions (that is, the loan and the derivative instrument) can be bundled in a structured note that could have almost an infinite variety of terms. The following presents 5 possible contractual terms for the structured note that would be purchased by Entity A for $900:

a
Note 1: Entity A is entitled to receive at the end of 1 year $954 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation's common stock over (or under) $200.
b
Note 2: Entity A is entitled to receive at the end of 1 year $955 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation's common stock over (or under) $201.
c
Note 3: Entity A is entitled to receive at the end of 1 year $755 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation's common stock over (or under) $1.
d
Note 4: Entity A is entitled to receive at the end of 1 year $1,054 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation's common stock over (or under) $300.
e
Note 5: Entity A is entitled to receive at the end of 1 year $1,060 plus any excess (or minus any shortfall) of the current per-share market price of XYZ Corporation's common stock over (or under) $306.

815-15-55-162

All of these five terms of a structured note will provide the same cash flows, given a specified market price of XYZ Corporation's common stock. If the market price of XYZ Corporation's common stock at the end of 1 year is still $200, Entity A will receive $954 under all 5 note terms. If the market price of XYZ Corporation's common stock at the end of 1 year increases to $306, Entity A will receive $1,060 under all 5 note terms.

815-15-55-163

For simplicity in constructing this Example, it is assumed that an equity-based cash-settled forward contract with a strike price equal to the stock's current market price has a zero fair value. In many circumstances, a zero-value forward contract can have a strike price greater or less than the stock's current market price.

815-15-55-164

The differences in the terms for these five notes are totally arbitrary because those differences have no effect on the ultimate cash flows under the structured note; thus, those differences are nonsubstantive and should have no influence on how the terms of an embedded derivative are identified. Therefore, the separation of the hybrid instrument into an embedded derivative and a host debt instrument should be the same for all five terms described above for the structured note (because they are merely different descriptions of the same ultimate cash flows). That bifurcation would generally result in the structured note being accounted for as a debt host contract with an initial carrying amount of $900 and a fixed annual rate of interest of 6 percent and an embedded forward contract with a $200 forward price, which results in an initial fair value of zero. Instead, if the five notes were bifurcated based on all their contractual terms, such bifurcation would be the equivalent of simply marking an arbitrary portion of a debt instrument to market based on nonsubstantive arbitrary differences in those contractual terms—an inappropriate outcome.

815-15-55-165

The following Cases illustrate the application of the guidance in this Subtopic to instruments that contain a variety of embedded derivatives:

a
Inverse floater (Case A)
b
Levered inverse floater (Case B)
c
Delevered floater (Case C)
d
Range floater (Case D)
e
Ratchet floater (Case E)
f
Fixed-to-variable note (Case F)
g
Indexed amortizing note (Case G)
h
Equity-indexed note (Case H)
i
Variable principal redemption bond (Case I)
j
Crude oil knock-in note (Case J)
k
Gold-linked bull note (Case K)
l
Step-up bond (Case L)
m
Credit-sensitive bond (Case M)
n
Inflation bond (Case N)
o
Disaster bond (Case O)
p
Specific equity-linked bond (Case P)
q
Dual currency bond (Case Q)
r
Short-term loan with a foreign currency option (Case R)
s
Lease payment in foreign currency (Case S)
t
Certain purchases in a foreign currency (Case T)
u
Convertible debt (Case U)
v
Dollar-denominated variable-rate interest issued by a special-purpose entity that holds yen-denominated variable-rate bonds and a cross-currency swap (Case V)
w
Variable-rate interest issued by a special-purpose entity that holds fixed-rate bonds and a pay-fixed, receive-variable interest rate swap (Case W)
x
Securitization involving subordination and variable-rate tranches (Case X)
y
Securitization involving subordination and fixed-rate tranches (Case Y)
z
Partially funded synthetic collateralized debt obligation with multiple tranches (Case Z)
aa
Fully funded synthetic collateralized debt obligation with multiple tranches (Case AA)
ab
Fully funded synthetic collateralized debt obligation with a single-tranche structure (Case AB).

815-15-55-166

Cases A through AB illustrate how the guidance in this Subtopic would be applied to contracts with the described terms. If the terms of a contract are different from the described terms, the application of this Subtopic by either party to the contract may be affected. Furthermore, if any contract of the types discussed in Cases A through AB meets the definition of a derivative instrument in its entirety under paragraphs

815-10-15-83 through 15-139

, the guidance for the application of the provisions of this Subtopic to embedded derivatives does not apply.

815-15-55-167

The illustrative instruments and related assumptions in Cases A through P are based on structured notes illustrated in paragraph 320-10-55-10.

815-15-55-168

Specifically, each Case does both of the following:

a
Provides a brief discussion of the terms of an instrument that contains an embedded derivative
b
Analyzes the instrument (as of the date of inception) in relation to the provisions of this Subtopic that require an embedded derivative to be accounted for according to this Subtopic if it is not clearly and closely related to the host contract.

815-15-55-169

Unless otherwise stated, Cases A through AB share both of the following assumptions:

a
If the embedded derivative and host portions of the contract are not clearly and closely related, a separate instrument with the same terms as the embedded derivative would meet the scope requirements in Section 815-10-15.
b
The contract is not remeasured at fair value under otherwise applicable GAAP with changes in fair value currently included in earnings.

815-15-55-170

An inverse floater is a bond with a coupon rate of interest that varies inversely with changes in specified general interest rate levels or indexes, for example, LIBOR.

815-15-55-171

Assume the coupon is 5.25 percent for 3 months to July 1994 and thereafter at 8.75 percent-6-month U.S. dollar (USD) LIBOR to January 1995. Assume the bond includes a stepping option that allows for spread and caps to step semiannually to maturity.

815-15-55-172

An inverse floater contains an embedded derivative (a fixed-for-variable interest rate swap) that is referenced to an interest rate index (in this circumstance, LIBOR) that alters net interest payments that otherwise would be paid by the debtor or received by the investor on an interest-bearing host contract. If the embedded derivative could potentially result in the investor's not recovering substantially all of its initial recorded investment in the bond (that is, if the inverse floater contains no floor to prevent any erosion of principal due to a negative interest rate), the embedded derivative is not considered to be clearly and closely related to the host contract (see paragraph 815-15-25-26[a]). In that circumstance, the embedded derivative should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic. (In this Case, there appears to be no possibility of the embedded derivative increasing the investor's rate of return on the host contract to an amount that is at least double the initial rate of return on the host contract [see paragraph 815-15-25-26(b)].) In contrast, if the embedded derivative could not potentially result in the investor's failing to recover substantially all of its initial recorded investment in the bond, the embedded derivative is considered to be clearly and closely related to the host contract and separate accounting for the derivative is neither required nor permitted.

815-15-55-173

A levered inverse floater is a bond with a coupon that varies indirectly with changes in general interest rate levels and applies a multiplier (greater than 1.00) to the specified index in its calculation of interest.

815-15-55-174

Assume that interest accrues at 6 percent to June 1994 and thereafter at 14.55 percent-(2.5x 3-month USD LIBOR).

815-15-55-175

A levered inverse floater can be viewed as an inverse floater in which the embedded interest rate swap is leveraged. Similar to Case A, the embedded derivative would not be clearly and closely related to the host contract if it potentially could result in the investor's not recovering substantially all of its initial recorded investment in the bond (see paragraph 815-15-25-26[a]) because there is no floor to the interest rate. In that circumstance, the embedded derivative (the leveraged interest rate swap) should be separated from the host contract and accounted for by both parties pursuant to the provisions of Subtopic. In contrast, if an embedded derivative could not potentially result in the investor's failing to recover substantially all of its initial recorded investment in the bond and if there was no possibility of the embedded derivative increasing the investor's rate of return on the host contract to an amount that is at least double the initial rate of return on the host contract (see paragraph 815-15-25-26[b]), the embedded derivative is considered to be clearly and closely related to the host contract and no separate accounting for the derivative is required or permitted.

815-15-55-176

A delevered floater is a bond with a coupon rate of interest that lags overall movements in specified general interest rate levels or indexes.

815-15-55-177

Assume that the coupon is (.5x 10-year U.S. Treasury constant maturities) + 1.25 percent.

815-15-55-178

A delevered floater may be viewed as containing an embedded derivative (a deleveraged swap or a series of forward contracts) that is referenced to an interest rate index (for example, 50 percent of 10-year U.S. Treasury constant maturities) that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract but could not potentially result in the investor's failing to recover substantially all of its initial recorded investment in the bond (see paragraph 815-15-25-26[a]). (In this circumstance, there appears to be no possibility of the embedded derivative increasing the investor's rate of return on the host contract to an amount that is at least double the initial rate of return on the host contract [see paragraph 815-15-25-26(b)].) The embedded derivative is considered to be clearly and closely related to the host contract as described in paragraph 815-15-25-26. Therefore, the embedded derivative should not be separated from the host contract.

815-15-55-179

A range floater is a bond with a coupon that depends on the number of days that a reference rate stays within a preestablished collar; otherwise, the bond pays either zero percent interest or a below-market rate.

815-15-55-180

Assume the investor receives 5.5 percent on each day that 3-month USD LIBOR is between 3 percent and 4 percent, with the upper limit increasing annually after a specified date. The coupon will be equal to 0 percent for each day that 3-month USD LIBOR is outside that range.

815-15-55-181

A range floater may be viewed as containing embedded derivatives (two written conditional exchange option contracts with notional amounts equal to the par value of the fixed-rate instrument) that are referenced to an interest rate index (in this instance, LIBOR) that alter net interest payments that otherwise would be paid by the debtor or received by the investor on an interest-bearing host contract but could not potentially result in the investor's failing to recover substantially all of its initial recorded investment in the bond (see paragraph 815-15-25-26[a]). In this instance, there appears to be no possibility of increasing the investor's rate of return on the host contract to an amount that is at least double the initial rate of return on the host contract (see paragraph 815-15-25-26[b]). The embedded derivatives are considered to be clearly and closely related to the host contract as described in paragraph 815-15-25-26. Therefore, the embedded derivatives should not be separated from the host contract.

815-15-55-182

A ratchet floater is a bond that pays a variable rate of interest and has an adjustable cap, adjustable floor, or both that move in sync with each new reset rate.

815-15-55-183

Assume the coupon is 3-month USD LIBOR + 50 basis points. In addition to having a lifetime cap of 7.25 percent, the coupon will be collared each period between the previous coupon and the previous coupon plus 25 basis points.

815-15-55-184

A ratchet floater may be viewed as containing embedded derivatives (combinations of purchased and written options that create changing caps and floors) that are referenced to an interest rate index (in this example, LIBOR) that alter net interest payments that otherwise would be paid by the debtor or received by the investor on an interest-bearing host contract but could not potentially result in the investor's failing to recover substantially all of its initial recorded investment in the bond (see paragraph 815-15-25-26[a]). In this Case, there appears to be no possibility of increasing the investor's rate of return on the host contract to an amount that is at least double the initial rate of return on the host contract (see paragraph 815-15-25-26[b]). The embedded derivatives are considered to be clearly and closely related to the host contract as described in paragraph 815-15-25-26. Therefore, the embedded derivatives should not be separated from the host contract.

815-15-55-185

A fixed-to-variable note is a bond that pays a varying coupon (first-year coupon is fixed; second- and third-year coupons are based on LIBOR, U.S. Treasury bills, or a prime rate).

815-15-55-186

A fixed-to-variable note may be viewed as containing an embedded derivative (a forward-starting interest rate swap) that is referenced to an interest rate index (such as LIBOR) that alters net interest payments that otherwise would be paid by the debtor or received by the investor on an interest-bearing host instrument but could not potentially result in the investor's failing to recover substantially all of its initial recorded investment in the bond (see paragraph 815-15-25-26[a]). Likewise, there is no possibility of increasing the investor's rate of return on the host contract to an amount that is both at least double the initial rate of return on the host contract and at least twice what otherwise would be the market return for a contract that has the same terms as the host contract and that involves a debtor with a similar credit quality (see paragraph 815-15-25-26[b]). The embedded derivative is considered to be clearly and closely related to the host contract as described in paragraph 815-15-25-26. Therefore, the embedded derivative should not be separated from the host contract.

815-15-55-187

An indexed amortizing note is a bond that repays principal based on a predetermined amortization schedule or target value. The amortization is linked to changes in a specific mortgage-backed security index or interest rate index. The maturity of the bond changes as the related index changes. This instrument includes a varying maturity. Assume that the contract does not meet the conditions in paragraph 815-15-25-26(a) or 815-15-25-26(b).

815-15-55-188

An indexed amortizing note can be viewed as a fixed-rate amortizing note combined with a conditional exchange option contract that requires partial or total early payment of the note based on changes in a specific mortgage-backed security index or a specified change in an interest rate index. Because the requirement to prepay is ultimately tied to changing interest rates, the embedded derivative is considered to be clearly and closely related to a fixed-rate note. Therefore, the embedded derivative should not be separated from the host contract.

815-15-55-189

An equity-indexed note is a bond for which the return of interest, principal, or both is tied to a specified equity security or index, for instance, the Standard and Poor's 500 S&P 500 Index. This instrument may contain a fixed or varying coupon rate and may place all or a portion of principal at risk.

815-15-55-190

An equity-indexed note essentially combines an interest-bearing instrument with a series of forward exchange contracts or option contracts. Often, a portion of the coupon interest rate is, in effect, used to purchase options that provide some form of floor on the potential loss of principal that would result from a decline in the referenced equity index. Because forward or option contracts for which the underlying is an equity index are not clearly and closely related to an investment in an interest-bearing note, those embedded derivatives should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

815-15-55-191

A variable principal redemption bond's principal redemption value at maturity depends on the change in an underlying index over a predetermined observation period. A typical circumstance would be a bond that guarantees a minimum par redemption value of 100 percent and provides the potential for a supplemental principal payment at maturity as compensation for the below-market rate of interest offered with the instrument.

815-15-55-192

Assume that a supplemental principal payment will be paid to the investor, at maturity, if the final S&P 500 closing value (determined at a specified date) is less than its initial value at date of issuance and the 10-year U.S. Treasury constant maturities is greater than 2 percent as of a specified date. In all circumstances, the minimum principal redemption will be 100 percent of par.

815-15-55-193

A variable principal redemption bond essentially combines an interest-bearing investment with an option that is purchased with a portion of the bond's coupon interest payments. Because the embedded option entitling the investor to an additional return is partially contingent on the S&P 500 index closing above a specified amount, it is not clearly and closely related to an investment in a debt instrument. Therefore, the embedded option should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

815-15-55-194

An illustrative crude oil knock-in note has a 1 percent coupon and guarantees repayment of principal with upside potential based on the strength of the oil market.

815-15-55-195

A crude oil knock-in note essentially combines an interest-bearing instrument with a series of option contracts. A significant portion of the coupon interest rate is, in effect, used to purchase options that provide the investor with potential gains resulting from increases in specified crude oil prices. Because the option contracts are indexed to the price of crude oil, they are not clearly and closely related to an investment in an interest-bearing note. Therefore, the embedded option contract should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

815-15-55-196

An illustrative gold-linked bull note has a fixed 3 percent coupon and guarantees repayment of principal with upside potential if the price of gold increases.

815-15-55-197

A gold-linked bull note can be viewed as combining an interest-bearing instrument with a series of option contracts. A portion of the coupon interest rate is, in effect, used to purchase call options that provide the investor with potential gains resulting from increases in gold prices. Because the option contracts are indexed to the price of gold, they are not clearly and closely related to an investment in an interest-bearing note. Therefore, the embedded option contracts should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

815-15-55-198

A step-up bond provides an introductory above-market yield and steps up to a new coupon, which will be below then-current market rates or, alternatively, the bond may be called in lieu of the step-up in the coupon rate.

815-15-55-199

A step-up bond can be viewed as a fixed-rate bond with an embedded call option and a changing interest rate feature. The bond pays an initial above-market interest rate to compensate for the call option and the future below-market rate (that is, below the forward yield curve, as determined at issuance based on the existing upward-sloping yield curve). Because the call option is related to changes in interest rates, it is clearly and closely related to an investment in a fixed-rate bond. Therefore, the embedded derivatives should not be separated from the host contract.

815-15-55-200

A credit-sensitive bond has a coupon rate of interest that resets based on changes in the issuer's credit rating.

815-15-55-201

A credit-sensitive bond can be viewed as combining a fixed-rate bond with a conditional exchange contract (or option contract) that entitles the investor to a higher rate of interest if the credit rating of the issuer declines. Because the creditworthiness of the debtor and the interest rate on a debt instrument are clearly and closely related, the embedded derivative should not be separated from the host contract.

815-15-55-202

An inflation bond has a contractual principal amount that is indexed to the inflation rate but cannot decrease below par; the coupon rate is typically below that of traditional bonds of similar maturity.

815-15-55-203

An inflation bond can be viewed as a fixed-rate bond for which a portion of the coupon interest rate has been exchanged for a conditional exchange contract (or option contract) indexed to the consumer price index, or other index of inflation in the economic environment for the currency in which the bond is denominated, that entitles the investor to payment of additional principal based on increases in the referenced index. Such rates of inflation and interest rates on the debt instrument are considered to be clearly and closely related. Therefore, the embedded derivative should not be separated from the host contract.

815-15-55-204

A disaster bond pays a coupon above that of an otherwise comparable traditional bond; however, all or a substantial portion of the principal amount is subject to loss if a specified disaster experience occurs.

815-15-55-205

A disaster bond can be viewed as a fixed-rate bond combined with a conditional exchange contract (an option contract). The investor receives an additional coupon interest payment in return for giving the issuer an option indexed to industry loss experience on a specified disaster. Because the option contract is indexed to the specified disaster experience, it cannot be viewed as being clearly and closely related to an investment in a fixed-rate bond. Therefore, the embedded derivative should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

815-15-55-206

However, if the embedded derivative entitles the holder of the option (that is, the issuer of the disaster bond) to be compensated only for changes in the value of specified assets or liabilities for which the holder is at risk (including the liability for insurance claims payable due to the specified disaster) as a result of an identified insurable event (see paragraphs

815-10-15-53 through 15-54

), a separate instrument with the same terms as the embedded derivative would not meet the definition of a derivative instrument in Section 815-10-15. In that circumstance, because the criterion in paragraph 815-15-25-1(c) would not be met, there is no embedded derivative to be separated from the host contract, and the disaster bond would not be subject to the requirements of this Subtopic. The investor is essentially providing a form of insurance or reinsurance coverage to the issuer.

815-15-55-207

A specific equity-linked bond pays a coupon slightly below that of traditional bonds of similar maturity; however, the principal amount is linked to the stock market performance of an equity investee of the issuer. The issuer may settle the obligation by delivering the shares of the equity investee or may deliver the equivalent fair value in cash.

815-15-55-208

A specific equity-linked bond can be viewed as combining an interest-bearing instrument with, depending on its terms, a series of forward exchange contracts or option contracts based on an equity instrument. Often, a portion of the coupon interest rate is used to purchase options that provide some form of floor on the loss of principal due to a decline in the price of the referenced equity instrument. The forward or option contracts do not qualify for the exception in paragraph 815-10-15-59(b) because the shares in the equity investee owned by the issuer meet the definition of a financial instrument. Because forward or option contracts for which the underlying is the price of a specific equity instrument are not clearly and closely related to an investment in an interest-bearing note, the embedded derivative should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic.

815-15-55-209

A dual currency bond provides for repayment of principal in U.S. dollars and periodic interest payments denominated in a foreign currency. In this circumstance, a U.S. entity with the dollar as its functional currency is borrowing funds from an independent party with those repayment terms as described.

815-15-55-210

Because the portion of this instrument relating to the periodic interest payments denominated in a foreign currency is subject to the requirement in Topic 830 to recognize the foreign currency transaction gain or loss in earnings, the instrument should not be considered as containing an embedded foreign currency derivative instrument pursuant to paragraph 815-15-15-5. In this circumstance, the U.S. entity has the dollar as the functional currency and is making interest payments in a foreign currency. Remeasurement of the liability is required using future equivalent dollar interest payments determined by the current spot exchange rate and discounted at the historical effective interest rate.

815-15-55-211

A U.S. lender issues a loan at an above-market interest rate. The loan is made in U.S. dollars, the borrower's functional currency, and the borrower has the option to repay the loan in U.S. dollars or in a fixed amount of a specified foreign currency.

815-15-55-212

This instrument can be viewed as combining a loan at prevailing market interest rates and a foreign currency option. The lender has written a foreign currency option exposing it to changes in foreign currency exchange rates during the outstanding period of the loan. The premium for the option has been paid as part of the interest rate. Because the borrower has the option to repay the loan in U.S. dollars or in a fixed amount of a specified foreign currency, the provisions of paragraph 815-15-15-5 are not relevant to this Case. That paragraph addresses foreign-currency-denominated interest or principal payments but does not apply to foreign currency options embedded in a functional-currency-denominated debt host contract. Because a foreign currency option is not clearly and closely related to issuing a loan, the embedded option should be separated from the host contract and accounted for by both parties pursuant to the provisions of this Subtopic. In contrast, if both the principal payment and the interest payments on the loan had been payable only in a fixed amount of a specified foreign currency, there would be no embedded foreign currency derivative pursuant to this Subtopic.

815-15-55-213

This Case involves a lease payment in foreign currency. A U.S. entity's operating lease with a Japanese lessor is payable in yen (JPY). The functional currency of the U.S. entity is the U.S. dollar (USD).

815-15-55-214

Using available information about the lessor and its operations, the U.S. entity may decide it is reasonable to conclude that JPY would be the currency of the primary economic environment in which the Japanese lessor operates, consistent with the functional currency notion in Topic 830.

815-15-55-215

Thus, the lease should not be viewed as containing an embedded swap converting USD lease payments to JPY. Alternatively, if the lease payments are specified in a currency seemingly unrelated to each party's functional currency, such as drachmas (GRD) (assuming the leased property is not in Greece), the embedded foreign currency swap should be separated from the host contract and accounted for as a derivative for purposes of this Subtopic because the provisions of paragraph 815-15-15-10 would not apply and a separate instrument with the same terms would meet the definition of a derivative instrument in Section 815-10-15.

815-15-55-216

Assume a U.S. entity enters into a contract to purchase corn from a local American supplier in six months for a fixed amount of Japanese yen (JPY); JPY is not the functional currency of either party to the transaction. The corn is expected to be delivered and used over a reasonable period in the normal course of business. Because JPY is not the functional currency of either party to the contract and the purchase of corn is transacted internationally in many different currencies, the contract does not qualify for the normal purchases and normal sales exception under Subtopic 815-10. The contract is a compound derivative comprising a U.S. dollar- (USD-) denominated forward contract for the purchase of corn and an embedded foreign currency swap from the purchaser's functional currency (USD) to JPY. The compound derivative instrument cannot be separated into its components (representing the foreign currency derivative instrument and the forward commodity contract) and accounted for separately under this Subtopic.

815-15-55-217

In a convertible debt instrument, an investor receives a below-market interest rate and receives the option to convert its debt instrument into the equity of the issuer at an established conversion rate. The terms of the conversion require that the issuer deliver shares of stock to the investor.

815-15-55-218

This instrument essentially contains a call option on the issuer's stock. Under the provisions of this Subtopic, the accounting by the issuer and investor can differ. The issuer's accounting depends on whether a separate instrument with the same terms as the embedded written option would be a derivative instrument pursuant to Section 815-10-15. Assuming the option is indexed to the issuer's own stock and a separate instrument with the same terms would be classified in stockholders' equity in the statement of financial position, the written option is not considered to be a derivative instrument for the issuer under paragraph 815-10-15-74(a) and should not be separated from the host contract.

815-15-55-219

In contrast, if the terms of the conversion allow for a cash settlement rather than delivery of the issuer's shares at the investor's option, the exception in paragraph 815-10-15-74(a) for the issuer does not apply because the contract would not be classified in stockholders' equity in the issuer's statement of financial position. In that circumstance, the issuer should separate the embedded derivative from the host contract and account for it pursuant to the provisions of this Subtopic because both of the following conditions exist:

a
An option based on the entity's stock price is not clearly and closely related to an interest-bearing debt instrument.
b
The option would not be considered an equity instrument of the issuer (see paragraph 815-40-25-4(a)(2)).

815-15-55-220

Similarly, if the convertible debt is indexed to another entity's publicly traded common stock, the issuer should separate the embedded derivative from the host contract and account for it pursuant to the provisions of this Subtopic because both of the following conditions exist:

a
An option based on another entity's stock price is not clearly and closely related to an investment in an interest-bearing note.
b
The option would not be considered an equity instrument of the issuer.

815-15-55-221

The exception in paragraph 815-10-15-74 does not apply to the investor's accounting. Therefore, in both circumstances described, the investor should separate the embedded option contract from the host contract and account for the embedded option contract pursuant to the provisions of this Subtopic because the option contract is based on the price of another entity's equity instrument and thus is not clearly and closely related to an investment in an interest-bearing note. However, if the terms of conversion do not allow for a cash settlement and if the common stock delivered upon conversion is privately held (that is, is not readily convertible to cash), the embedded derivative would not be separated from the host contract because it would not meet the criteria for net settlement as discussed beginning in paragraph 815-10-15-99.

815-15-55-222

Assume a dollar-denominated variable-rate interest is issued by a special-purpose entity that holds yen-denominated variable-rate bonds and a cross-currency swap to pay yen and receive dollars. If the variable rate reflects a current market rate and the notional amounts of the bonds and the swap correspond to the notional amount of the interests issued, the dollar-denominated variable-rate interest would not have an embedded derivative requiring bifurcation because the terms of the beneficial interest do not indicate an embedded derivative and the financial instruments held by the entity provide the necessary cash flows.

815-15-55-223

Assume a variable-rate interest is issued by a special-purpose entity that holds fixed-rate bonds and a pay-fixed, receive-variable interest rate swap. The variable-rate interest would not have an embedded derivative requiring bifurcation because the terms of the beneficial interest do not indicate an embedded derivative and the financial instruments held by the entity provide the necessary cash flows. However, if the notional amounts of the fixed-rate bonds and the variable interest rate swap do not match, the variable-rate interest would have to be evaluated for an embedded derivative under paragraph 815-15-25-26 because the financial instruments held by the entity might not provide the necessary cash flows.

815-15-55-224

Assume a special-purpose entity that holds nonprepayable fixed-rate bonds issues all of the following three tranches:

a
A senior, variable-rate financial instrument (with a limited exposure to credit losses on the fixed-rate bonds)
b
A subordinated financial instrument that is entitled to 90 percent of the difference between the fixed rate received from the bonds and the variable rate paid to the senior financial instrument (with a limited exposure to credit losses on the fixed-rate bonds)
c
A residual financial instrument that is entitled to the remainder of the fixed-rate payment from the bonds after any credit losses on the fixed-rate bonds.

815-15-55-225

Each of the three tranches in the preceding paragraph would be a hybrid financial instrument with an embedded interest rate derivative feature that requires bifurcation analysis under paragraph 815-10-15-11 and Section 815-15-25 because the terms are variable rate even though the entity does not hold assets that bear a variable rate. This analysis considers the structure as a whole including the related liabilities. The embedded interest rate derivative feature in the senior, variable-rate financial instrument is considered to be clearly and closely related to the host contract. With respect to the subordinated financial instrument and the residual financial instrument, there could be a shortfall of cash flow after the senior interest holders are paid, due to adverse changes in interest rates, and the investor in either the subordinated interest or the residual interest might not recover substantially all of its initial recorded investment in the interest; thus, the embedded interest rate derivative feature is considered to be not clearly and closely related to the host contract. Therefore, the embedded interest rate derivative should be separated from the host contract and accounted for in accordance with the provisions of this Subtopic. Paragraph 815-15-15-9 is not relevant because risk features other than credit risk are present in the beneficial interests that require application of paragraph 815-10-15-11 and Section 815-15-25.

815-15-55-226

Assume a special-purpose entity that holds prepayable fixed-rate loans issues all of the following three tranches:

a
A senior, fixed-rate financial instrument that is entitled to receive fixed-rate interest payments and all the prepayments and repayments of principal amounts received from the debtors (with a limited exposure to credit losses on the fixed-rate loans)
b
A subordinated, fixed-rate financial instrument that is entitled to receive fixed-rate interest payments and the prepayments and repayments of principal amounts received from the debtors only after the holders of the senior financial instrument have been paid in full (with a limited exposure to credit losses on the fixed-rate loans)
c
A residual financial instrument that is entitled to the remainder of the fixed-rate interest payments from the loans and the prepayments and repayments of principal amounts received from the debtors only after the holders of both the senior financial instrument and the subordinated financial instrument have been paid in full. All credit losses on the fixed-rate loans are absorbed first by the holders of the residual financial instrument.

815-15-55-226A

Each of the three tranches in the preceding paragraph would be a hybrid financial instrument with an embedded derivative feature. Because the embedded derivative feature involves only the transfer of credit risk that is only in the form of subordination of one financial instrument to another (assuming that the investor did not pay a significant premium for the interest in the tranche), the scope exception in paragraph 815-15-15-9 applies, and the embedded credit derivative feature existing in the tranches would not be subject to the application of paragraph 815-10-15-11 and Section 815-15-25.

815-15-55-226B

Assume a special-purpose entity that holds guaranteed investment contracts and that wrote a credit default swap on a referenced credit to a third party with a significantly larger notional amount than the guaranteed investment contracts issues various tranches of credit-linked beneficial interests to investors that differ in terms of priority and in their potential obligation to fund any losses on the credit default swap. That is, if credit losses greater than the value of the guaranteed investment contracts are incurred under the credit default swap, the investors in each of the tranches might be required to provide additional funds to the special-purpose entity, which would then pass those funds on as payments to the holder of the credit default swap. Because the investors in those tranches are exposed to making potential future payments, all the embedded derivative features would be subject to the application of paragraph 815-10-15-11 and Section 815-15-25 (provided that the investor's overall contract is not a derivative in its entirety under Section 815-10-15). While the risk in those tranches is credit related, the investor can lose more than its original investment. Therefore, the credit risk for those tranches is not related only to subordination and would be evaluated under paragraph 815-10-15-11 and Section 815-15-25, particularly paragraph 815-15-25-51A.

815-15-55-226C

Assume a special-purpose entity that holds securities issued by AA-rated Entity A and that wrote a credit default swap on a referenced credit (BBB-rated Entity B) to a third party (with a smaller notional amount than the securities held) issues various tranches of credit-linked beneficial interests to investors that differ in terms of priority for the distribution of cash flows from the special-purpose entity. The assets in the special-purpose entity are sufficient to fund any losses on the credit default swap. Furthermore, none of the tranches expose the investor to making potential future payments related to defaults on the written credit default swap. Rather, the investor is exposed to a potential reduction in its future cash inflows, which is the effect of the credit risk related to the credit default swap. That reduction in future cash flows is allocated among the tranches by the subordination of one tranche to another. Each of the tranches would be a hybrid financial instrument with an embedded credit derivative feature that requires bifurcation analysis under paragraph 815-10-15-11 and Section 815-15-25 because the beneficial interests are exposed to credit risk from the securities held (Entity A) and also from credit risk introduced by the credit default swap (Entity B) and, thus, the payments to investors would be affected if either Entity A or Entity B defaults. The embedded credit derivative feature in the beneficial interests would not be clearly and closely related to the host contract under Section 815-15-25. Therefore, the embedded credit derivative feature should be separated from the host contract and accounted for in accordance with the provisions of this Subtopic. Paragraph 815-15-15-9 is not relevant because the embedded credit risk is not related solely to subordination.

815-15-55-226D

Assume a special-purpose entity that holds securities issued by AA-rated Entity C and that wrote a credit default swap on a referenced credit (BBB-rated Entity D) to a third party uses a single-tranche structure to issue credit-linked beneficial interests to multiple investors. The assets in the special-purpose entity are sufficient to fund any losses on the credit default swap. Because the single-tranche structure involves no subordination of one financial instrument to another, the scope exception in paragraph 815-15-15-9 does not apply. The embedded credit derivative feature existing in the beneficial interests would be subject to the application of paragraph 815-10-15-11 and Section 815-15-25, as discussed in Case AA.

815-15-55-227

To illustrate the host contract and embedded derivative valuation issues in this Subtopic, consider the following equity-indexed annuity point-to-point design example, which includes a minimum account value stated as a return on the principal amount of the annuity.

Initial premium " $100,000 " Participation rate "100% participation in the equity returns, credited at the end of the contract term" Contract term 3 years Minimum account value at the end of the contract term "$103,030 ($100,000 compounded annually at the minimum accumulation rate of 1% per year)" Implied option strike price Current S&P 500 X 1.0303 Embedded option valuation "Monte-Carlo-Option model calculated value at $20,000 at inception"

815-15-55-228

At inception, the insurer has received $100,000, recorded as follows.

Cash " $100,000 " Embedded derivative " $20,000 " Host zero-coupon debt obligation " 80,000 "

815-15-55-229

In the preceding journal entry, paragraphs 815-15-30-2 and 815-15-35-3 are followed: the embedded derivative is recorded at fair value, and the carrying value assigned to the host contract is the difference between the proceeds received from the issuance of the hybrid instrument and the fair value of the embedded derivative.

815-15-55-230

Accordingly, in this Example, the host contract would be accreted annually to the minimum account value at the end of the contract ($103,030) using an effective yield method (in this Example, the implicit interest rate underlying the host is 8.8 percent).

815-15-55-231

From the issuer's (insurer's) perspective, an equity-indexed annuity liability comprises a fixed annuity host and an embedded written equity option. The embedded equity option should be accounted for under the provisions of Subtopic 815-10. The fixed annuity component should be accounted for under the provisions of Topic 944 that require debt instrument accounting. In this Example, the host contract is a discounted debt instrument that should be accreted using the effective yield method to its minimum account value at the projected maturity or termination date.

815-15-55-232

Upon receipt of consideration for an equity-indexed annuity, the issuing entity should allocate a portion of the consideration to the embedded written option, as described in paragraphs 815-15-30-2 and 815-15-35-3, that is, the fair value of the option is assigned to the embedded derivative. The remainder of the consideration should be assigned to a fixed annuity host contract. Both credited interest and changes in the fair value of the embedded equity option would be recognized in earnings. Accordingly, in this Example, the host contract would be accreted annually to the minimum account value at the end of the contract ($103,030) using an effective yield method (in this example, the implicit interest rate underlying the host is 8.8 percent).

815-15-55-233

The following Cases illustrate valuation of the components under the following scenarios at the end of Year 1:

a
Standard and Poor's Index increases (Case A).
b
Standard and Poor's Index decreases (Case B).

815-15-55-234

The components are valued as follows.

Embedded derivative " $28,968 " (Assumed) Accreted value of host contract " 87,032 " "($80,000 x 1.088)" Value of hybrid instrument " $116,000 "
Value under Topic 944 (in absence of this Subtopic): $115,000 ($100,000 at 15% return)

815-15-55-235

Note that because of the market's implicit valuation of future volatility in the Standard and Poor's Index, as reflected in the fair value of the embedded derivative, the combined value of the embedded derivative and the host contract is greater than that which would be calculated for the contract as a whole under Topic 944. The proper accounting in this Case is to record a total liability of $116,000, the hybrid contract value under this Subtopic.

815-15-55-236

The components are valued as follows.

Embedded derivative " $7,968 " Accreted value of host contract " 87,032 " Value of hybrid instrument " $95,000 "
Value under Topic 944 (in absence of this Subtopic): $101,000 ($100,000 at 1% return)

815-15-55-237

The components already reflect the application of paragraph 815-15-25-1 (the derivative instrument is measured at fair value) and paragraph 815-15-25-4 (the host contract is accreted like a debt instrument).

815-15-55-238

As a result, the equity-indexed annuity liability would be recorded at $95,000 at the end of Year 1. A separate Topic 944 calculation of account value is no longer required because the derivative instrument is carried at fair value in accordance with this Subtopic and the host contract is recorded following the GAAP accounting guidance for an investment contract under that Topic. Therefore, the insurer should ignore any minimum liability that exceeds the sum of the embedded derivative separately accounted for and the host debt instrument that is accounted for applying the debt model.

815-15-55-239

This Example illustrates the application of paragraph 815-15-15-15 to the cited contract.

815-15-55-240

On March 1, 20X0, Entity A enters into a Japanese yen- (JPY-) denominated forward purchase agreement to purchase a specified quantity of widgets in six months from Entity B. Entity A's functional currency is the U.S. dollar (USD) and Entity B's functional currency is JPY. The spot JPY/USD foreign exchange rate at the inception of the agreement is USD 1.00 equals JPY 110.00. Entity A wishes to collar its foreign exchange rate risk by ensuring that it will never pay more than the JPY equivalent to USD 11.00 per widget in return for committing to Entity B that it will never pay less than the JPY equivalent to USD 8.80 per widget. The agreement defines the price according to the following schedule.

When USD 1.00 equals . . . The JPY price per widget is . . . More than JPY 125 The JPY equivalent to USD 11.00 Between JPY 100 and JPY 125 "JPY 1,100" Less than JPY 100 The JPY equivalent to USD 8.80

815-15-55-241

Entity A is exposed to foreign exchange risk in the range between JPY 100 and JPY 125, whereas Entity B is exposed outside that range. The following are various scenarios.

Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5 Foreign exchange rate (JPY/USD) 110/1 125/1 100/1 80/1 135/1 Purchase price (JPY) " 1,100 " " 1,100 " " 1,100 " 880 " 1,188 " USD-equivalent purchase price 10.00 8.80 11.00 11.00 8.80

815-15-55-242

In essence, Entity A has not locked in a USD price or a JPY price for the purchased widgets. Instead, as desired, Entity A has locked in a price range in its functional currency (USD) between USD 8.80 and USD 11.00 for the purchased widgets. The final price to be paid within this range will be determined based on the JPY/USD foreign exchange rate. Based on the terms, the contract contains an embedded cap and floor (options). For purposes of this Example, assume that the combination of options represents a net purchased option for Entity A.

815-15-55-243

The embedded foreign currency options within Entity A's purchase contract would qualify for the exclusion under paragraph 815-15-15-15 for purposes of Entity A's accounting because all of the following conditions exist:

a
The options are denominated in JPY and USD (the functional currencies of both parties to the contract).
b
There is no leverage feature within the options.
c
The combination of foreign currency options represents a net purchased option.

815-15-65Transition and Open Effective Date Information

Source downloaded: 2026-09-10T01:36:28.479Z.Record version 127c8c103841. Effective date must be checked in the source.

815-15-65-1

Paragraph superseded on 06/20/2011 after the end of the transition period stated in Accounting Standards Update No. 2010-08, Technical Corrections to Various Topics.

815-15-65-2

Paragraph superseded on 06/20/2018 after the end of the transition period stated in Accounting Standards Update No. 2014-16, Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity.

815-15-65-3

Paragraph superseded on 07/17/2019 after the end of the transition period stated in Accounting Standards Update No. 2016-06, Derivatives and Hedging (Topic 815): Contingent Put and Call Options in Debt Instruments.

In brief

815-15-00Status

815-15-05Overview and Background

815-15-15Scope and Scope Exceptions

Entities

Instruments

815-15-25Recognition

Fair Value Election for Hybrid Financial Instruments

Compound Embedded Derivative

Interests in Securitized Financial Assets—Holder's Accounting

Applying the Separate Instrument Criterion

Applying the Clearly-and-Closely Related Criterion

Entity Unable to Reliably Identify and Measure Embedded Derivative

Host Contract After Separation

815-15-30Initial Measurement

Hybrid Instruments That Are Not Separated

Hybrid Instruments That Are Separated

815-15-35Subsequent Measurement

Hybrid Instruments That Are Not Separated

Hybrid Instruments That Are Separated

Embedded Conversion Option That No Longer Meets Bifurcation Criteria

815-15-40Derecognition

Embedded Conversion Option that No Longer Meets Bifurcation Criteria

815-15-45Other Presentation Matters

815-15-50Disclosure

Hybrid Instruments That Are Not Separated

Embedded Conversion Option that Is No Longer Bifurcated

815-15-55Implementation Guidance and Illustrations

Implementation Guidance

Illustrations

815-15-65Transition and Open Effective Date Information

Related subtopics