PwC Guide Derivative instruments and hedging activities

620 Pages·2015·3.05 MB·English

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Copyright © 2013-2015 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and
may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.
This publication has been prepared for general information on matters of interest only, and does not
constitute professional advice on facts and circumstances specific to any person or entity. You should
not act upon the information contained in this publication without obtaining specific professional
advice. No representation or warranty (express or implied) is given as to the accuracy or
completeness of the information contained in this publication. The information contained in this
material was not intended or written to be used, and cannot be used, for purposes of avoiding
penalties or sanctions imposed by any government or other regulatory body.
PricewaterhouseCoopers LLP, its members, employees and agents shall not be responsible for any
loss sustained by any person or entity who relies on this publication.

The content of this publication is based on information available as of March 31, 2013. Accordingly,
certain aspects of this publication may be superseded as new guidance or interpretations emerge.
Financial statement preparers and other users of this publication are therefore cautioned to stay
abreast of and carefully evaluate subsequent authoritative and interpretative guidance that is issued.

This publication has been updated to reflect new and updated authoritative and interpretative
guidance since the 2012 edition. See Appendix B for a Summary of significant changes.
“Portions of FASB Accounting Standards Codification®, copyrighted by the Financial Accounting
Foundation, 401 Merritt 7, Norwalk, CT 06856, are reproduced with permission.”
PwC guide library
Other titles in the PwC accounting and financial reporting guide series:
□ Bankruptcies and liquidations (2014)
□ Business combinations and noncontrolling interests, global edition (2014)
□ Consolidations (2015)
□ Fair value measurements, global edition (2015)
□ Financial statement presentation (2014), Second edition
□ Financing transactions: debt, equity and the instruments in between (2014),
Second edition
□ Foreign currency (2014)
□ IFRS and US GAAP: similarities and differences (2015)
□ Income taxes (2013), Second edition
□ Revenue from contracts with customers, global edition (2014)
□ Stock-based compensation (2013), Second edition
□ Transfers and servicing of financial assets (2013)
□ Utilities and power companies (2013)
□ Variable interest entities (2013), Second edition
To Our Clients and Friends:
PricewaterhouseCoopers is pleased to offer this updated comprehensive guide, which
is meant to help you meet the challenges of accounting for derivative instruments and
hedging activities. Domestically and internationally, the volume, variety, and inherent
complexity of derivative transactions have steadily increased and the nature of
hedging activities continues to evolve. In practice, hedge accounting is difficult to
apply and leads to divergent interpretations. For this reason, the use of derivative
instruments and related hedging activities still attracts heightened scrutiny from
regulators and other interested parties.
In this guide we attempt to clarify a complex area of accounting by providing relevant
guidance and examples. We also add our own perspective throughout, based on both
our analysis of the guidance and our experience in applying it.
The FASB continues to amend and provide further clarification of the accounting and
disclosure requirements for derivative and hedging activities to keep pace with the

ever evolving nature of derivative transactions. Additional FASB guidance is sure to
come, since practice issues will continue to arise in this area. We will keep you up-to-
date on new guidance through further communications whenever it is necessary and
useful.
Although this publication is intended to clarify the fundamental requirements of
accounting for derivative instruments and to highlight key points that should be
considered before transactions are undertaken, it is not a substitute for a thorough
analysis of the facts and circumstances surrounding proposed transactions, nor
should it be read in place of the relevant accounting literature. Nonetheless, we trust
that you will find in these pages information and insights that will allow you to work
with greater confidence and certainty when accounting for derivative instruments and
hedging activities.
PricewaterhouseCoopers LLP
Table of contents
Chapter 1: Executive summary
1.1 Historical perspective ...................................................... 1-2
1.2 Fundamental principles of accounting for derivatives
and hedging activities ....................................................... 1-2
1.3 Challenges associated with accounting for derivatives
and hedging activities ....................................................... 1-4
1.3.1 Securing resources with the appropriate background
and work experience ........................................................ 1-4
1.3.2 Preparing hedge documentation ...................................... 1-4
1.3.3 Coordinating between departments ................................. 1-5
1.3.4 Applying hedge accounting and the shortcut method ........ 1-5
1.3.5 Identifying embedded derivatives .................................... 1-5
1.4 How entities have responded ........................................... 1-6
1.5 Looking forward: Considerations for accounting for
derivatives and hedging activities ..................................... 1-6
1.6 A note about this guide ..................................................... 1-8
Chapter 2: Scope
Executive takeaway .......................................................... 2-2
2.1 Definition and scope ........................................................ 2-2
2.1.1 Underlying, notional amount and payment provision ...... 2-3
2.1.2 Initial net investment ....................................................... 2-5
2.1.3 Net settlement .................................................................. 2-6
2.1.3.1 Net settlement under contract terms ................................................. 2-6
2.1.3.2 Net settlement through a market mechanism ................................... 2-8
2.1.3.3 Net settlement by delivery of derivative instrument or asset
readily convertible to cash ................................................................. 2-10
2.2 Contracts excluded from ASC 815’s scope ......................... 2-12
2.2.1 Regular-way security trades ............................................. 2-12
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2.2.2 Normal purchases and normal sales ................................. 2-13
2.2.2.1 Qualifying criteria for the normal purchases and normal sales
exception ............................................................................................ 2-13
2.2.2.2 Freestanding option contracts ........................................................... 2-17
2.2.2.3 Forward (non-option-based) contracts ............................................. 2-17
2.2.2.4 Forward contracts that contain optionality features ......................... 2-18
2.2.2.5 Power purchase or sale agreements ................................................... 2-19
2.2.3 Certain insurance contracts ............................................. 2-21
2.2.4 Certain financial guarantee contracts ............................... 2-22
2.2.5 Certain contracts that are not traded on an exchange ....... 2-23
2.2.6 Derivative instruments that impede sale accounting ........ 2-25
2.2.7 Investments in life insurance ........................................... 2-25
2.2.8 Certain investment contracts ........................................... 2-25
2.2.9 Certain loan commitments ............................................... 2-26
2.2.10 Leases .............................................................................. 2-26
2.2.11 Residual value guarantees ................................................ 2-26
2.2.12 Registration payment arrangements ................................ 2-27
2.3 Certain contracts involving an entity’s own equity ............ 2-28
2.3.1 Contracts indexed to, and potentially settled in, an entity’s
own stock ......................................................................... 2-28
2.3.1.1 Determining whether a contract is indexed to an entity’s
own stock ............................................................................................ 2-29
2.3.1.2 Determining whether a contract is classified in stockholders’
equity .................................................................................................. 2-31
2.3.2 Share-based payments ..................................................... 2-32
2.3.3 Forward contracts to enter into a business combination .. 2-34
2.3.4 Financial instruments within the scope of ASC 480 .......... 2-34
2.4 Examples of contracts that meet the definition of a
derivative ......................................................................... 2-35
Exhibit 2-1 Table of derivatives: Contract types ................................ 2-35
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2.5 Questions and interpretive responses .............................. 2-40
Question 2-1 Derivative-like instruments ....................................... 2-40
Question 2-2 Forward commitment in a securitization
transaction .......................................................................................... 2-40
Question 2-3 Short sales ................................................................. 2-41
Question 2-4 Commodity requirements contracts ......................... 2-41
Question 2-5 Payment provisions ................................................... 2-42
Question 2-6 Payment provisions ................................................... 2-42
Question 2-7 “Regular-way” securities trades ................................ 2-43
Question 2-8 “Regular-way” securities trades ................................ 2-43
Question 2-9 To-be-announced or when-issued securities
trades .................................................................................................. 2-43
Question 2-10 Take-or-pay contracts ............................................. 2-44
Question 2-11 Fair value option ...................................................... 2-45
Question 2-12 Option to purchase leased property ........................ 2-45
Question 2-13 Accounting for weather derivatives ........................ 2-45
Question 2-14 Royalty agreements ................................................. 2-46
Question 2-15 Stock purchase warrants ......................................... 2-47
Question 2-16 Entities that record financial instruments at
fair value ............................................................................................. 2-50
Question 2-17 Continual reassessment of nonderivative
contracts ............................................................................................. 2-51
Question 2-18 Continual reassessment of nonderivative
contracts ............................................................................................. 2-51
Question 2-19 Continual reassessment of nonderivative
contracts ............................................................................................. 2-52
Question 2-20 Impracticability of a fair value estimate ................ 2-53
Question 2-21 Repurchase agreements .......................................... 2-53
Question 2-22 Application of ASC 815 to not-for-profit
organizations ...................................................................................... 2-54
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Table of contents
Chapter 3: Embedded derivative instruments
Executive takeaway .......................................................... 3-2
3.1 Hybrid instruments, host contracts, and embedded
derivatives ....................................................................... 3-4
Exhibit 3-1 Types of embedded features added to host contracts ..... 3-5
3.1.1 Identifying an embedded derivative ................................. 3-5
3.1.1.1 Determining embedded vs. freestanding ........................................... 3-6
3.1.2 Defining the host contract ................................................ 3-7
3.1.3 SEC views on identifying host contracts and
embedded features ........................................................... 3-8
3.2 Bifurcation of the hybrid instrument ................................ 3-8
3.2.1 Reserved
3.2.2 Reserved
3.2.3 Application exception for interest-only and principal-only
strips ................................................................................ 3-11
3.2.4 Application exception for foreign exchange contracts ...... 3-11
Exhibit 3-2 Decision tree for determining whether or not to
bifurcate a hybrid instrument and separately account for
the embedded derivative .................................................................... 3-13
3.3 Other considerations ........................................................ 3-14
3.3.1 Issuer and investor asymmetry ........................................ 3-14
Exhibit 3-3 Examples of hybrid instruments with
asymmetrical accounting ................................................. 3-14
3.3.2 Timing and frequency of assessment ................................ 3-15
3.3.3 Multiple derivative features ............................................. 3-16
3.4 Debt hosts ........................................................................ 3-17
3.4.1 Common embedded features in debt hosts ....................... 3-18
3.4.1.1 Interest-bearing host contracts with interest rate underlyings ........ 3-19
3.4.2 Callable and puttable debt ................................................ 3-21
3.4.3 Issuer’s accounting for convertible debt ........................... 3-23
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3.4.3.1 Indexed to the company’s own stock ................................................. 3-23
3.4.3.2 Classified as shareholders’ equity if freestanding ............................. 3-25
3.4.4 SEC views on freestanding and embedded conversion
features and share settled features ................................... 3-28
3.4.5 Beneficial interests in securitizations ............................... 3-30
3.4.5.1 Accounting for derivatives embedded in beneficial interests ........... 3-31
3.4.5.2 Embedded credit derivatives ............................................................. 3-35
3.4.5.3 Application exception for beneficial interests in prepayable
securitized assets ................................................................................ 3-37
Exhibit 3-4 Decision tree for application of ASC 815 to
beneficial interests in securitizations ................................................ 3-40
3.5 Equity hosts ..................................................................... 3-41
3.5.1 SEC’s views on determining debt vs. equity hosts ............. 3-41
3.5.2 Calls and puts on equity hosts .......................................... 3-42
3.6 Other host contracts ......................................................... 3-43
3.6.1 Executory contract hosts .................................................. 3-43
3.6.2 Insurance hosts ................................................................ 3-44
3.6.3 Lease hosts ....................................................................... 3-44
3.7 Accounting considerations for hybrid instruments .......... 3-45
3.7.1 Allocating basis ................................................................ 3-45
Exhibit 3-5 Separating option-based and non-option-
based embedded derivatives ............................................. 3-47
3.7.2 Conversion options no longer requiring bifurcation —
revised July 2015 .............................................................. 3-47
3.7.3 Fair value option (FVO) for hybrid instruments ............... 3-48
3.8 Transition guidance ......................................................... 3-49
3.8.1 Embedded derivatives grandfathered at adoption of
ASC 815 ............................................................................ 3-49
3.9 Questions and interpretive responses .............................. 3-50
Question 3-1 Hybrids accounted for at fair value ........................... 3-50
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Question 3-2 Bifurcation ................................................................. 3-50
Question 3-3 Debt with caps and floors ......................................... 3-51
Question 3-4 Convertible debt ........................................................ 3-51
Question 3-5 Convertible debt ........................................................ 3-52
Question 3-6 Debt with commodity-price indexation .................... 3-53
Question 3-7 Debt with leverage-adjusted principal ...................... 3-54
Question 3-8 Debt with puts, calls, and term-extending
options ................................................................................................ 3-55
Question 3-9 Debt with puts, calls, and term-extending
options ................................................................................................ 3-56
Question 3-10 Non-benchmark variable rate debt ......................... 3-57
Question 3-11 Cash collateralized debt obligation (CDO) .............. 3-58
Question 3-12 Synthetic CDO with a credit default swap .............. 3-58
Question 3-13 Synthetic CDO with a credit default swap .............. 3-59
Question 3-14 Credit linked note .................................................... 3-59
Question 3-15 Other implementation questions ............................ 3-60
Question 3-16 Other implementation questions ............................ 3-60
Question 3-17 Foreign currency instruments ................................. 3-61
Question 3-18 Foreign currency instruments ................................ 3-61
Question 3-19 Foreign currency instruments ................................ 3-62
Question 3-20 Foreign currency instruments ................................ 3-62
Question 3-21 Traditional life insurance ........................................ 3-63
Question 3-22 Variable-annuity products ...................................... 3-63
Question 3-23 Equity-indexed annuity .......................................... 3-64
Question 3-24 Property and casualty insurance ............................ 3-64
Question 3-25 Disaster bonds ........................................................ 3-64
Question 3-26 ModCo arrangements ............................................. 3-65
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