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Fair Value Considerations Related to the Accounting for Embedded Derivatives

User Contributed News – Accounting guidance around embedded derivatives is a reasonably mature topic with SFAS 133, Accounting for Derivative Instruments and Hedging Activities, released in 1998 (now ASC Topic 815). Still, this remains a complex area of accounting due to the variety and technical nature of both the financial instruments and the identified derivatives. Two of the primary reporting challenges are (1) applying specific tests to ascertain whether something is indeed an embedded derivative, and (2) further assessing whether changes in value should be measured in current earnings. Identification and intent – determining whether a derivative is a hedge – presents a litany of accounting issues and tests behind them. Fortunately, the concept of fair value is not connected to these accounting intricacies. Given the complexity and the uniqueness in accounting for derivatives, it is not surprising that ASC 815 has numerous EITFs and FSPs that pertain to the application of the standard, some of which include fair value issues. This issue of the Alert highlights the role of fair value with respect to the financial reporting requirements associated with embedded derivatives.

WITH AND WITHOUT” ANALYSIS
Accounting tests for embedded derivatives look toward the economic substance of the instrument including items that are relevant to fair value, such as cash flows and rates of return. If the original investment can settle in a way where substantial loss is possible or where a rate of return received could be twice that of a comparable market rate of return, then an embedded derivative is likely present. In these instances, financial reporting separates the feature(s) to account directly for their values on a periodic basis, while separately accounting for the basic instrument (e.g. a bond or term loan). The valuation process becomes a “with and without” analysis that isolates the value of the embedded derivative by measuring the difference in the host contract’s value with and without the isolated feature. In this context, the resulting cash flow(s) should be discounted at an appropriate rate to measure the fair value of the embedded derivative.

Where do we most often encounter fair value requirements related to embedded derivatives? From an instrument perspective, we mostly see accounting treatment identify embedded derivatives as part of a debt instrument (the host contract). We have recently encountered earlier stage companies in both the life science and technology sectors issuing debt instruments where embedded derivatives have been bifurcated. These companies displayed interesting financing histories that included creative capital raises balancing near-term cash requirements with future payoffs in the event of a successful liquidity event. Such financing is facilitated by the presence of embedded derivatives, which impart a balance between risk and return while managing the cost of financing from the company’s perspective.

A recent example involved a company seeking bridge financing prior to a material equity round or a significant liquidity event. Often such debt issuances are made to existing equity investors providing the company with needed capital at a time where, from an operating perspective, the company is at an inflection point with respect to milestones or product launches. The bridge financing contains triggering provisions that either settled the debt at a significant multiple (e.g. 1.5x or greater) to the invested principal, or offered favorable conversion rights at a significant multiplier given a particular outcome.

VALUATION PROCESS
A starting point when analyzing a debt instrument with one or more embedded derivative features is to ascertain whether the derivatives involve a conversion option into equity, or are limited specifically to the future cash flows in the form of interest and principal. This will lead to two different valuation paths, specifically risk-neutral versus risk-adjusted. Assuming the less complex situation, that conversion to equity is not involved, a first step is estimating the instrument’s underlying implied or par yield giving consideration only to the baseline cash flows, which may, for example, require adjustment for put/call features, attached warrants or PIK interest (the “without” scenario). From there, the impact of the embedded derivative(s) can be modeled based on their terms and with assistance from management regarding estimates for probability, timing, etc.

The value of the embedded derivative can be viewed in the context of the additional yield, or spread, required to price the debt at par (issue price) given the impact of the derivative(s) on future cash flows (the “with” scenario). If more than one derivative is present, the impact can be isolated and valued individually. The appropriate discount factor is based on the specific yield that prices the instrument at its transaction price (usually par) given the expected cash flows resulting from the derivative(s). This is the essence of the “with and without” model construct that focuses on cash flow.

Embedded derivatives require valuation at issuance and revaluation at all subsequent quarters with changes in value reported in earnings (non-cash). Analyzing the instrument and embedded derivatives at issuance is especially helpful since there is an observable transaction price; future valuations will not have this luxury. In the early quarters it is often reasonable to assume a constant price or yield, unless it is clear something has changed at the company. As time goes by, other important indicators often become part of the valuation picture.

Occasionally the yield may seem challenging to support from a straight-debt perspective, looking more equity-like. High yields are often supported by the significant financing risk and the potential for sudden change in scenario probabilities that reflect the dynamic position of the company. As the embedded derivative is evaluated over time, the resulting yield implied by the “with” scenario should be tracked and evaluated for reasonableness. We note that as probabilities in scenarios change over time, the value in the embedded derivatives can change substantially.

The Lowe Group
(262) 893-1696

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