PICPA Don�t Trip Over that Embedded Derivative
Post on: 21 Май, 2015 No Comment
Spring 2008
Thomas Rees, CPA
Few accounting rules have caused financial statement preparers and their auditors more headaches than Statement of Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivatives and Hedging Activities.
The Financial Accounting Standards Board (FASB) has amended SFAS 133 several times since its initial issuance in June 1998, most recently with the issuance of SFAS 155, Accounting for Certain Hybrid Financial Instruments. In addition, FASB, through its Derivatives Implementation Group, issued specific implementation guidance on more than 180 topics. All told, the standard, its amendments, and its implementation guidance provide nearly 1,000 pages of accounting guidelines for the complex instruments known as derivatives. No wonder SFAS 133 has tripped up numerous public registrants, both big and small.
One of the most confusing elements of the accounting standard are the rules relating to embedded derivatives. These requirements are particularly complex, requiring practitioners to consult a seemingly endless stream of Derivatives Implementation Group issuances, Emerging Issues Task Force (EITF) pronouncements, and SEC staff guidance to determine the appropriate accounting. Numerous companies have tripped over the embedded derivative issue. According to the Analyst’s Accounting Observer, 92 companies filed Form 8-K in 2006 to indicate that they would restate their financial statements due to incorrect application of EITF Issue No. 00-19 (EITF 00-19), one of the most important pronouncements in determining the appropriate accounting for embedded derivatives.
This article summarizes the basic accounting requirements for embedded derivatives, provides examples of how certain contractual terms could have unintended accounting consequences, and offers suggestions on how to mitigate the accounting risk these terms raise.
Embedded Derivative
SFAS 133 characterizes an embedded derivative as a provision within a contract, or other instrument, that affects some or all of the cash flows or the value of that contract, similar to a derivative instrument. Essentially, the embedded terms contain all of the attributes of a free-standing derivative—such as an underlying market variable, a notional amount or payment provision, no initial net investment, and can be settled net—but the contract, in its entirety, does not meet the SFAS 133 definition of a derivative.
By embedding terms that meet the definition of a derivative into another contract—the host contract—that contract’s cash flows may be modified when changes in specified underlying market variables occur. The contract that embodies both the derivative and the host contract is referred to as a hybrid instrument. Embedded derivatives appear in a variety of contracts, including foreign exchange contracts, lease agreements, insurance contracts, and other arrangements. One of the most common locations for these terms, and an area that has been a primary focus of the SEC, is convertible debt and preferred stock instruments.
For example, assume Trina Company needs working capital and is planning to raise $10 million of funding through capital markets. Based on market conditions and its credit rating, Trina Company plans to issue straight debt that pays a 9 percent fixed rate of interest every six months until maturity in 10 years. The debt is considered straight debt because the instrument contains no significant terms that will affect future interest or principal payments. In other words, it has no embedded derivatives.
Assume that Trina Company discusses its planned debt issuance with an investment banker, who suggests altering the straight debt plan to reduce the company’s cost of funds. Accordingly, Trina Company agrees to provide investors with a redemption, or put, option that enables the holder to redeem the debt after five years. It also adds a provision that enables the holder to convert each $1,000 of principal into 25 shares of Trina Company’s common stock if certain contingencies are met, or any time after seven years. To provide additional protection to the investor, Trina Company includes a provision that, if a change in control of the company occurs, it will pay the holder $300 per $1,000 of principal outstanding, less any previously paid interest, in addition to returning the $1,000 in principal and retiring the debt. This is typically referred to as a make-whole provision. Finally, for its own protection, Trina Company adds a call option, giving it the right to retire the debt after seven years. By adding these terms, the required interest rate on the debt is reduced from a 9 percent fixed rate to 6 percent fixed.
Each one of these provisions has the potential to change the future cash flow of the straight debt, depending on changes to underlying market variables—such as market interest rates or Trina Company’s stock price—and therefore may be considered an embedded derivative. In this example, the straight debt is considered the host instrument; the put option, conversion option, make-whole provision, and call option are considered embedded derivatives; and the convertible debt instrument in its entirety is considered a hybrid instrument. To determine the appropriate accounting for this instrument, both the issuer and the investor must consult a wide range of accounting literature, including SFAS 133, various Statement 133 implementation issues—commonly referred to as Derivatives Implementation Group issuances—and FASB’s EITF guidance.
Standard Complexity
When SFAS 133 was implemented, one of the changes it made was that all derivatives had to be accounted for at fair value on the balance sheet, no exceptions. This approach is consistent with the view that fair value is the only meaningful way to measure a derivative, and with FASB’s stated objective of moving toward full fair-value accounting for all financial instruments. Accounting for derivatives at fair value, however, may result in more volatility in a company’s reported earnings. FASB was concerned that methods would be found to circumvent the SFAS 133 mark-to-market requirement by embedding a derivative in another financial instrument, avoiding the potential volatility in reported earnings that a derivative could cause. Accordingly, FASB included special accounting requirements for embedded derivatives in SFAS 133.
Accounting Requirements
The fundamental concept for embedded derivatives is relatively simple: An embedded term that meets the definition of a derivative, and which is not economically related to the host instrument, is subject to special accounting. Specifically, such embedded derivatives may have to be accounted for separately, as if they were stand-alone derivative instruments. FASB uses the word bifurcation to describe the process of separating the embedded derivative from the instrument in which it resides and accounting for them as if they were two distinct financial instruments. Failure to comply with this requirement has been one of the primary sources of SFAS 133 implementation errors, and the cause of numerous restatements.
SFAS 133’s core criteria for determining the appropriate accounting treatment for embedded derivatives is contained in what, on the surface, is a relatively simple three-part test in paragraph 12. Briefly, this test is as follows:
- Would the embedded term meet the definition of a derivative if it was a stand-alone instrument? If no, the embedded term does not require separate accounting. If yes, go to the next question. When considering this question, the analysis must consider the specific SFAS 133 scope exclusions specified in paragraphs 10 and 11.
- Is the instrument in which the term is embedded (the hybrid instrument) accounted for at fair value? If yes, the embedded term is already accounted for at fair value, and separate accounting is not required. If no, go to the next question.
- Are the economic characteristics of the embedded derivative clearly and closely related to the economic characteristics of the host instrument? If the embedded derivative is considered economically closely related to the instrument in which it resides, separate accounting is not required. If the answer to this question is no, the embedded derivative should be accounted for as a separate asset or liability.
The concepts outlined in the three-part test are relatively simple, but the implementation and interpretation of the requirements is complicated. In fact, FASB included implementation guidance on this issue within SFAS 133 and then separately released 40 derivatives implementation issues to help interpret the accounting requirements. In addition, there are numerous EITF pronouncements that must be consulted when performing an embedded derivative analysis. The list of accounting guidance that must be consulted to complete this simple analysis is extremely long, and is not for the faint of heart. 1
Because this area has been a common cause of accounting errors, I want to highlight two specific elements of the related accounting literature that seem to be the most confusing.
The double-double test—SFAS 133, paragraph 13, indicates that an embedded derivative that only alters the amount of interest paid on a debt instrument would be considered clearly and closely related to the host instrument, and thus would not require separate accounting. If there is a possible future interest rate scenario in which settlement of the debt could result in either the investor earning a negative rate of return, or a rate of return that is both more than twice the initial rate of return and twice the then-current market rate of return, it would not be considered clearly and closely related to a debt host instrument. This double-double test gets its name from the criterion that requires analyzing whether the embedded derivative term could cause the doubling of both the initial interest rate and the current market rate of interest for a debt instrument of similar credit quality. In other words, if there is any possible scenario in which the investor could earn a future rate of return that is both double the initial rate of the instrument and double the interest rate of a debt instrument of similar credit quality, the embedded derivative would generally need to be accounted for separately from the debt host.
FASB Statement 133’s Implementation Issue No. B16, Embedded Derivatives: Calls and Puts in Debt Instruments, provides applicable guidance and should be consulted when considering the appropriate accounting for these terms.
Paragraph 11(a) scope exception—SFAS 133, paragraph 11(a), indicates that contracts issued or held by that reporting entity that are both indexed to its own stock and classified in stockholder’s equity in its statement of financial position are outside the scope of SFAS 133. In other words, such terms meet the equity definition and do not have to be accounted for separately. EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, provides guidance that must be considered when determining whether an embedded derivative meets the definition of equity.
EITF 00-19 requires the issuer to determine whether there is any possibility, even if it is remote, that the embedded derivative could be settled for cash. If the possibility exists, EITF 00-19 requires that the derivative be accounted for as a liability and not as equity. Therefore, it would not be eligible for the paragraph 11(a) scope exception. EITF 00-19 specifies eight criteria that must be met to conclude that the instrument would always be settled in shares and not in cash. The following three criteria often cause embedded derivatives involving share settlements to fail the test:
- The contract permits the company to settle the embedded derivative in unregistered shares.
- The issuing company has sufficient, authorized, and un-issued shares available to settle the embedded derivative contract after considering all other obligations to issue such shares.
- The contract contains an explicit limit on the number of shares to be delivered in a share settlement.
- These criteria are applicable when analyzing the conversion feature embedded in debt or preferred stock. If any one of the eight EITF 00-19 criteria is not met with regard to settlement of the conversion feature in shares, then the embedded conversion feature must be accounted for separately.
SEC Focus
The SEC’s Division of Corporation Finance is specifically focusing on embedded derivatives in debt and preferred stock instruments in their review of registrant financial statements. Accordingly, companies that have issued debt or preferred stock that contain embedded derivatives can expect to receive a comment letter from the SEC requesting additional information to support the accounting approach that was followed. A typical comment letter might ask for the details of the analysis of the provisions of EITF 00-19 and SFAS 133 with respect to the accounting for convertible debt.
SEC staff has addressed the accounting requirements for embedded derivatives in speeches at the annual 2005 and 2006 AICPA conferences. In addition, EITF issued D-109 and revised D-98 in March 2007 to provide specific updates from the SEC on how to analyze these transactions. The SEC also addressed accounting requirements in two recent issuances of Current Accounting and Disclosure Issues in the Division of Corporation Finance.
Suggestions to Mitigate Accounting Risk
Since tripping over an embedded derivative is by no means unheard of, and easy to do, below are a few suggestions that may help you identify or avoid accounting errors related to embedded derivatives.
Review existing financial instruments for embedded derivatives. If your organization or client has not formally reviewed each financial instrument/contract to identify embedded derivatives, this should be done immediately. Ideally, one or more individuals should be responsible for reviewing newly acquired financial instruments to determine the appropriate accounting at the inception of the transaction. Documentation of the review should be maintained. This is an important consideration in an external auditor’s evaluation of the company’s internal controls over financial reporting, as required under Section 404 of Sarbanes-Oxley.
Before entering into new transactions, make sure all parties involved are aware of the potential accounting implications. In particular, individuals in the treasury function or others authorized to enter into capital market transactions must understand the accounting requirements of the transaction being considered prior to execution of the trade. SFAS 133 requires companies to evaluate both the financial instrument and the specific terms within it. Accordingly, when raising capital through a debt or preferred stock issuance, all of the terms in the instrument must be considered. Similar analyses should be conducted before purchasing securities issued by other entities. Consult with attorneys to understand the requirements of the instruments being contemplated.
Discuss the accounting implications of transactions and obtain agreement on the proposed accounting from independent accountants before entering the transaction. In general, external auditors have become more reluctant to provide accounting guidance on hypothetical transactions for fear of impairing their independence. If this is the case, consider identifying and retaining third-party consultants who can provide technical advice.
Consider the provisions in SFAS 155 and SFAS 159 that provide entities with the option to elect to account for instruments containing embedded derivatives at fair value rather than separate accounting for the derivative element.
Continue to monitor developments at FASB and SEC for new guidance. This has been an area of significant activity, and FASB has several projects on its agenda relating to derivatives accounting and convertible debt instruments.
www.aicpa.org.
Thomas Rees, CPA, is a director in FTI Consulting’s King of Prussia office, where he provides SEC advisory services. He can be reached at thomas.rees@fticonsulting.com .