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If a loan is callable by the lender upon an event of default, there may be an embedded derivative.

The call provision is in effect a contingent put exercisable by the lender. This provision meets the definition of a derivative under ASC 815. Next test is whether the provision is clearly and closely related to the debt-host contract. At first glance, a default clause would be considered clearly and closely related. However, when you apply the 4-step process outlined in DIG No. B16 and IF the contingent put is exercisable at a substantial premium, you’ll find yourself with an embedded derivative requiring bifurcation.

Note that the premium is measured by reference to the debt’s carrying value, so any discount arising at inception must be factored into the calculation. There is frequently a discount when debt is issued with other securities such as detachable stock purchase warrants or when the debt has a beneficial conversion feature. Even if there is no premium, you must also determine if there is an unusually high rate of return to the lender as a result of the default.

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