Application examples

The following examples illustrate the application of the guidance for determining whether an embedded put and call option should be separated from a debt instrument and accounted for as a derivative.

EXAMPLE 1-1

Debt puttable upon a change in interest rates

J&N Corp issues a fixed-rate debt instrument with a term of five years, at par value.

The debt contains a put option, which allows the lender to put the debt, when there is an increase in the 6-month LIBOR rate of 150 basis points or more, and receive 105%

of the debt’s par value.

Is the embedded put option clearly and closely related to the debt host?

Analysis

J&N Corp performs the analyses in Figure 1-1 as illustrated below.

EXAMPLE 1-2

Debt issued at par, puttable upon a change in control

J&N Corp issues a fixed-rate debt instrument with a term of five years, at par value.

The debt contains a put option, which allows the lender to put the debt, when there is a change in control (defined in the debt agreement), and receive 105% of the debt’s par value. J&N Corp determines that a change in control during the next five years is unlikely.

Is the embedded put option clearly and closely related to the debt host?

Is the amount paid upon exercise of the put option based on changes in an index?

Does exercise of the put option accelerate the repayment of the debt?

Is the put option contingently exercisable?

Does the debt involve a substantial premium or discount?

Perform the analysis to determine whether there is an interest rate derivative that should be accounted for separately.

No, upon exercise of the put option the investor will receive 105% of the par value of the bond.

Yes, the put option requires the issuer to repay the debt instrument at 105% of the par value upon exercise of the put option.

Yes, the put option can only be exercised by the investor when there is an increase in the 6-month LIBOR rate of 150 basis points.

No, the debt was issued at par value and the premium received upon exercise of the put option (5%) is less than 10% of the par value of the bond.

Since this is a put option and would be solely indexed to interest rates, the guidance in ASC 815-15-25-26(b) should be considered. Because it is possible for the investor to double its initial rate of return and double the then-current market rate of return for the host debt instrument through exercise of the put option, for example if 6-month LIBOR increased to 151 basis points the day after the debt was issued and the investor put the debt to the issuer at 105% of par, there is an embedded interest rate derivative to be accounted for separately.

Analysis

J&N Corp performs the analyses in Figure 1-1 as illustrated below.

The put option is clearly and closely related to its debt host. It should not be accounted for separately.

EXAMPLE 1-3

Debt issued at a premium, puttable upon a change in control

J&N Corp issues a fixed-rate debt instrument with a term of five years, at 102% of par value. The debt contains a put option, which allows the lender to put the debt, when there is a change in control (defined in the debt agreement), and receive par value.

Perform the analysis to determine whether there is an interest rate derivative that should be accounted for separately.

Is the amount paid upon exercise of the put option based on changes in an index?

No, upon exercise of the put option the investor will receive 105% of the par value of the bond.

Does exercise of the put option accelerate the repayment of the debt?

Yes, the put option requires the issuer to repay the debt instrument at 105% of the par value upon exercise of the put option.

Is the put option contingently exercisable?

Yes, the put option can only be exercised by the investor when there is a change in control.

Does the debt involve a substantial premium or discount?

No, the debt was issued at par value and the premium received upon exercise of the put option (5%) is less than 10% of the par value of the bond. In addition, J&N Corp has determined that a change in control during the term the debt is outstanding is unlikely.

The put option is contingently exercisable based on a change in control, therefore is based on a contingency other than interest rates. As such, the put option would not be analyzed under the guidance in ASC 815-15-25-26.

Is the embedded put option clearly and closely related to the debt host?

Analysis

J&N Corp performs the analyses in Figure 1-1 as illustrated below.

The put option is clearly and closely related to its debt host. It should not be accounted for separately.

EXAMPLE 1-4

Debt issued at a discount, puttable upon a change in control

J&N Corp issues a fixed-rate debt instrument with a term of five years, at 80% of par value. The debt contains a put option, which allows the lender to put the debt, when there is a change in control (defined in the debt agreement), and receive par value.

.

Is the amount paid upon exercise of the put option based on changes in an index?

Does exercise of the put option accelerate the repayment of the debt?

Is the put option contingently exercisable?

Yes, the put option can only be exercised by the investor when there is a change in control.

Does the debt involve a substantial premium or discount?

No, upon exercise of the put option the investor will receive the par value of the bond.

Yes, the put option requires the issuer to repay the debt instrument at par value upon exercise of the put option.

No, the debt was issued at 102% of par value, thus the premium is less than 10%

of the par value of the bond. There is no premium received upon exercise of the put option.

Perform the analysis to determine whether there is an interest rate derivative that should be accounted for separately.

The put option is contingently exercisable based on a change in control; therefore, it is based on a contingency other than interest rates. As such, the put option would not be analyzed under the guidance in ASC 815-15-25-26.

Is the embedded put option clearly and closely related to the debt host?

Analysis

J&N Corp performs the analyses in Figure 1-1 as illustrated below.