Posted by & filed under Derivatives, Equity-Linked Transactions.

The issue of whether you have a freestanding instrument or an embedded feature is one of scope.  Specifically, freestanding instruments are potentially subject to accounting standards that are not applicable to embedded features. For example, ASC 480, Liabilities РDistinguishing Liabilities from Equity, applies only to freestanding instruments. Therefore a threshold requirement to further analysis is making this determination.

Perhaps the easiest way to make this determination is to look at the nature of an embedded feature. ¬†An embedded feature is not something that can be sold or traded separately from the host contract…that is, the contract in which the rights and/or obligations of the feature are embedded. For example, a conversion option in a debt instrument does not have a separate existence without the debt instrument. If the debt instrument ceases to exist through repayment or expiration, the conversion option also ceases to exist. Also, contractually, a convertible debt agreement does not typically contemplate separation of the conversion option from the contract. This would require, instead, a new agreement between one party to the convertible debt agreement and a third party.

The ASC Master Glossery does not provide a definition of an ’embedded feature’, yet the term is used liberally in certain sections of the ASC. As a practical matter, an ’embedded feature’ is a contractual element of a freestanding instrument. An ’embedded feature’, unlike a freestanding instrument, has no substantive existence without the freestanding instrument’s existence. So, even though an embedded feature can be entered into as a separate contractual agreement, it is not entered into separately and and apart from any other instrument; rather, it will specifically reference the instrument to which it is contractually attached. So ask yourself this question, “Does this agreement or contractual provision have the ability to stand on its own as if the host contract or any other agreement does not exist?” If the answer is ‘no’, you have an embedded feature for accounting purposes.

A freestanding instrument is just that, an instrument that stands on its own, that exists based on its own terms independent of the existence of some other instrument or agreement. So, look at the terms of you instrument and evaluate its terms. Does its terms provide for its existence regardless of any other instrument or agreement? If no, then your instrument is probably not freestanding and should be evaluated as a unit with the other instrument(s) or agreement(s) on which its existence is dependent. Going back to the conversion option above, it is not uncommon for a conversion option to be written as a separate agreement from the debt agreement. This can happen at inception of the debt agreement or at some point thereafter. Regardless, the conversion option, even though in a separate agreement, is in substance an embedded feature since its existence is dependent upon the existence of the debt agreement. Therefore, the debt agreement and the conversion option agreement should be combined and evaluated together as a freestanding agreement.

Depending upon the accounting result determined for the combined instruments as a unit, you may still need to subsequently evaluate an embedded feature separately. But, this would only come after first evaluating the freestanding instrument. For example, if the freestanding instrument is determined to be a derivative reported at fair value, then there is no need to separately report the embedded feature. This analysis tool will tell you whether or not you need to evaluate embedded features based upon the analysis of the freestanding instrument. Evaluation of an equity-linked transaction is first performed to the freestanding instrument and then, and only under certain circumstances, must you then subsequently evaluate the freestanding instrument’s embedded features.

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