Definition of a Derivative
A qualifying derivative must satisfy three criteria (815-10-15):
- It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. These contractual terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.
- It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
Complicating the process for assessing whether or not any contractual arrangement qualifies as a derivative is the fact the FASB has scoped out a host of situations that might otherwise appear to satisfy the above definition.
- Regular-way securities trades, where delivery occurs within the time frame of normal market conventions.
- Normal purchases and normal sales where instruments will be delivered in amounts expected to be used within a reasonable period of time in the normal course of business and where there is a high probability that the contracts will result in physical deliver. Contracts that required periodic cash settlements (e.g., futures contracts) do not qualify for this exception.
- Certain insurance contracts which generally fall under FAS 60, 07, and 113. Contracts are exempt from treatment as a derivative if the payout compensates the insured for an identifiable insurable event other than a change in price.
- Financial guarantee contracts that reimburse for specific losses due to defaults of debtors.
- Off-exchange contracts where settlement amounts are based on (a) climactic, geological, or other physical variables; (b) prices of non-financial assets or liabilities on either party to the contract, where the underlying instrument is not readily convertible to cash; or (c) specific volumes of sales or revenues of one of the parties to the contract.
- Derivatives that serve as impediments to sales accounting.
- Contracts (a) indexed to a company’s own stock and classified in stockholders’ equity; (b) issued by the reporting entity relating to stock-based compensation; or (c) issued as a contingent consideration from a business combination.
Embedded derivative instruments
Embedded derivatives are components of contractual arrangements that, by themselves (i.e. on a stand-alone basis), would satisfy the criteria in the definition of a derivative. Embedded derivatives are often present in structured note contracts and other debt obligations, but they may also be found in such contracts such as leases, purchase agreements, insurance contracts, guarantees, and other tailored arrangements.
Embedded derivatives reside in “host” contracts; and the combined instrument (i.e., the host and the embedded derivative) is referred to as the “hybrid instrument.”
In general, embedded derivatives must be separated from the host contract for accounting purposes. Provided they meet the qualifying criteria for being a derivative under the FASB criteria, embedded derivatives must be accounted for as if they were free standing derivatives, unless (a) the characteristics and risks of the embedded derivative are clearly and closely related to those of the host, or (b) the hybrid instrument is re-measured at fair value with changes reported in earnings.
If the embedded derivative incorporates a leverage factor or if an investor may not recover substantially all of the initial recorded investment, the embedded derivative would be required to be accounted for separately from the host. (815-15-25)
Interest-only and principal-only strips are specifically exempted from being treated as derivatives, provided (a) the original securities from which these derivatives were constructed have no embedded derivatives that would otherwise be covered under FAS 133, and (b) the strips do not contain any features that were not initially a part of the original instrument. (815-10-15)
Embedded foreign currency derivatives are exempt from treatment as a derivative if (a) the host is not a financial instrument and settlements are required in the functional currency of any substantial party to the contract, or (b) the settlements are denominated in the currency of the price that is routinely used for international commerce of the underlying good or service. (815-15-10)