This is the first in a series of posts exploring derivative accounting guidance. The focus of these posts will be the effect derivative accounting has on traditional equity and debt capital raising transactions. I’ll start with the basics and move into some meaty areas that are common pitfalls.
There are three criteria to the accounting definition of a derivative:
a) There are i) one of more ‘underlyings’ and ii) one or more ‘notionals’ or payment provisions, or both;
b) There is no initial investment or an investment that is smaller than that normally expected of a contract that responds to market changes in a similar manner (i.e., delivers net gains and losses);
c) The contract can be net settled under the contract terms (i.e., the party in the net loss position ‘pays’ the party in the net gain position), through a market mechanism (e.g., the contract trades on an exchanged) or by delivery of a derivative or delivery of an asset that is readily convertible to cash (e.g., publicly traded stock).
This post covers the first criteria.
In a derivative, the ‘underlying’ and the ‘notional amount’ combine to determine the settlement amount of the instrument…the amount that one party will have to pay the other party in cash, stock or other consideration. The underlying introduces variability into the contract value. As the underlying moves, so moves the contract value. The variability can be a smooth 1-to-1 relationship, a multiple or fractional relationship, or a cliff.
The underlying is generally a referenced rate, index or measurable event. The notional amount may be a number of units (bushels or pounds for example), a number shares, a specified fixed dollar amount or some other unit of measure specified in the instrument. Typically, the settlement amount is determined by simply multiplying the underlying by the notional amount. For example, in the cashless settlement of a warrant, the settlement amount is determined by multiplying the number of shares (the notional amount) by the difference between the stock price (the underlying) and the warrant strike price. In other cases, the settlement formula may be more complex and introduce leverage or other factors that affect the final settlement amount.
As an alternative to a notional amount, some instruments may provide for a payment provision that specifies a fixed or determinable settlement to be made if the underlying behaves in a certain way. For example, the instrument may specify that a $1,000,000 payment is to be made in the event that the price of gold increases by $200. In this case, the underlying (the price of gold) alone drives settlement of the contract since there is no notional amount; however, the requirements of ASC 815-10-15-93 are met since movement of the underlying acts as an ‘on-off switch’ in determining whether or not the payment provision is triggered.
These types of underlyings are common in debt instruments that have default provisions that alter the economic value of the contract upon events of default. For example, if the contract interest rate increases upon an event of default, that default event triggers the interest rates increase and is therefore an underlying. The payment provision is the increased amount of interest payable. Thus, the first criteria is met. An important concept in derivative accounting, however, is that the underlying must be outside the control of the company. So, not all events of default are necessarily underlyings. As long as the company controls whether or not the event occurs then it is not an underlying; however, the level of control can not be partial or incomplete. On the surface, failure to make a timely principal payment, for example, would appear to be within the control of the company. Not necessarily true. Many factors affect the ability to make a contractual payment, including having the available funds. Some of these factors may not be within the control of the company. Here’s another example. Default for failure to deliver financial statements is probably within the control of the company. Failure to deliver AUDITED financial statements is NOT within the control of the company since the audit opinion is issued by the auditors, not the company.
Fortunately, while many default provisions in debt may meet the technical definition of a derivative, they are often scoped out of derivative accounting by the concept of ‘clearly and closely related to the host contract”. I’ll cover that concept in a future post.