Derivative Financial Instruments
Overview: Financial instruments often contain certain features which are considered derivative instruments which may require fair value accounting under ASC 815, Derivatives and Hedging (pre-Codification Statements on Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities). These derivatives come in many forms. Some examples are:
- Variable conversion features embedded in debt agreements
- Anti-dilution protection
- Incremental penalties upon an event of default
- Mandatory conversion features
- Redemption rights
- Term-extending options
- Additional investment rights
These derivatives may require asset or liability classification which requires that they be recorded at fair value each reporting period. Valuation of these instruments can often be complex since ASC 815 explicitly precludes accounting discretely for each embedded derivative. DIG B-15, Separate Accounting for Multiple Derivative Features Embedded in a Single Hybrid Contract provides that a company is not permitted to separate a compound derivative instrument into components representing different risks and then account for those components separately. Instead, a valuation approach must be used which bundles all the embedded derivative features together as a single compound embedded derivative instrument which is then bifurcated and recorded at a single fair value. Alternatively, a company may choose a fair value election under ASC 815, and fair value the entire hybrid contract.
Based on Staff comments published by the SEC, it appears that the SEC does not believe that the Black-Scholes model captures the interest rate risk, credit risk, probability of exercise of the right of the holders and other factors that drive the fair value of complex derivative instruments. Accordingly, a more complex valuation model is required.
Services: Our clients often ask us to perform fair value measurements for derivative financial instruments. Our valuation professionals use a number of different valuation techniques based on the risks associated with the derivative to determine the most appropriate method of valuing the compound derivative. We then present calculated amounts by applying the Statement on Standards for Valuation Services, published by the AICPA and we provide a workbook with the calculations and the journal entries that are needed to mark these compound derivatives to fair value each reporting period.
Case Study: A client came to us because they had a new convertible financing and their auditors had made them aware of the fact that there were complex accounting standards which had to be considered when valuing the instrument. They asked us to review their financing agreement to determine the proper accounting treatment of the components of the transaction and perform the fair value calculations. When analyzing the contract, we discovered 14 derivatives embedded into one convertible debt contract and determined that 6 of these derivatives required bifurcation. We were able to create a valuation model which calculated the fair value of one compound derivative which embodied the risks associated with these 6 derivatives. The client was able to provide the auditors with the fair value calculations and supporting detail for their audit workpapers.