For accounting purposes, an embedded feature is any feature that introduces variability into a contract with otherwise fixed terms. The contract can be anything, really…a loan, a share of stock, a lease, an insurance policy or any other agreement entered into by two parties. An embedded feature alters the economic value of the contract to the parties based on a measurement outside the contract such as an index (e.g., stock market average or a benchmark interest rate), an event (e.g., completion of an IPO, occurrence of geological or weather events), or really anything that the parties agree to. Exercise of the embedded feature can be mandatory or optional, and settlement of the economic results can be physical (one party delivers cash and the other party delivers item or items specified in the contract), or net (one part delivers cash and the other party delivers the item or items that represent the net gain/loss to each party).
Identifying embedded features can be difficult. A thorough reading and understanding of the contract terms is essential. Read every word and consider each provision’s economic effect on the contract. Look for words and phrases like option, right, choice, contingent, based on, by reference to, indexed to, convert, and exercise. These words and phrases convey to one party the ability to alter the economic outcome of the contract or its settlement results, or attaches determination of the economic outcome to some outside, observable result.
Embedded features are subject to special accounting rules that are complex and subject to judgment. Analyzing any embedded feature is conditioned upon understanding thoroughly the terms and condition of the agreement and any other agreements issued at the same time or potentially previously with the same party. There is no shortcut. Read and reread the contract. If you have any questions or need clarity, consult with the parties that negotiated the terms or with the attorney that drafted the agreement. In our SOX-regulated financial reporting environment, not understanding the terms of an agreement can lead to material misstatements and material weaknesses in internal controls.