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 potentially subject to special accounting rules separate and apart from the contract itself. These rules are complex and subject to judgment. Properly 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.
In practice, embedded features that require separate accounting are most prevalent in debt instruments. Investors will often enhance both secured and unsecured loans with returns based on the occurrence or none occurrence of all sorts of things including stock market performance, earthquakes, governmental approvals, and on and on. Leases can contain similar provisions. Equity shares, usually preferred shares, can contain embedded features that give the shares the characteristics of debt or that provide returns to the investor based on measurements unrelated to the company, such as the S&P 500.