ASC 815-14-25-4 provides an entity the option to treat an entire contract containing one or more embedded derivative features as a hybrid instrument reported at fair value with changes in fair value included in earnings. By electing this option, the entity may avoid the cost and complexity of accounting for one or more bifurcated embedded derivative features. In fact, this is typically the reason this election is made. Once an embedded derivative feature has been bifurcated from the host contract, it must be measured at fair value at inception and at each balance sheet date thereafter. If there are multiple embedded features that warrant bifurcation as embedded derivatives, those features must be bundled together and accounted for separately as a single compound embedded derivative. It does not take long for the valuation costs of an individual bifurcated feature or that of a compound derivative to exceed that of the entire instrument. Additionally, the sum of the changes in fair value of the individual embedded features if bifurcated and accounted for separately may represent the bulk of the change in fair value of the entire hybrid instrument.
In addition to the cost and complexity issues avoided by making this election, there is also the question of whether a bifurcated embedded derivative feature can be reliably measured. While a feature may meet the definition of a derivative and not meet any of the scope exceptions, valuation of the bifurcated feature may not be possible. Valuation is based on the assumption that you have a willing buyer and a willing seller. Valuation also assumes that you have something that can be the subject of an exchange. Some embedded features just don’t make sense in the context of these assumptions due to contingent events that must occur in order for the features to have any economic value. From a valuation perspective, determining the probability of a contingent event occurring is highly subjective. As a result, valuation experts will occasionally say that the valuation is not possible. In this circumstance, the fact that the embedded derivative feature cannot be reliably measured precludes bifurcation and the entity has no choice but to report the entire instrument as a hybrid at fair value.
This fair value election must be made at the inception of the instrument and is irrevocable. The election is available on an instrument-by-instrument basis only the instrument contains an embedded derivative requiring bifurcation. Therefore, the entity must perform and document an analysis of the embedded feature(s) to eligible for the election. Alternatively, the company may adopt a policy of automatic election and apply that policy to any eligible instruments entered into subsequent to adoption of the policy. This automatic election may help avoid some of the analysis and documentation requirements; however, most valuation experts will require an analysis of the features regardless of the guidance requirements.