Loan relationships: ‘hybrid’ securities with embedded derivatives: accounting treatment: mechanics of bifurcation
How a company bifurcates
A company which is a creditor or debtor for a convertible or exchangeable security, or an asset-linked security, is generally required to account separately for the loan and the ‘embedded derivative’, from the time it first acquired the security. It must allocate initial values to the two components whether or not it was a party to the security when originally issued.
The accounting treatment is different for the issuers and holders of hybrids (loan host with embedded derivative) and the issuers of compound instruments (loan host plus an equity component from the issuer’s perspective).
Valuation of the components is a specialised exercise, see CFM25000. The embedded derivative (the conversion or exchange rights or obligations in the case of a convertible or exchangeable security, or the asset link rights in the case of an asset linked security) within a hybrid financial instrument is measured at fair value. The fair value of the derivative component is determined separately using an appropriate valuation model. The different between the fair value of the derivative and the fair value of the contract as a whole is allocated to the loan host contract (that is, the loan host contract is valued as a residual amount).
If, however, it is impossible to reliably value the derivative as a separate instrument (for example, because the derivative is based on unquoted shares), its fair value is taken as being the difference between the fair value of the whole instrument and the fair value of the loan component.
The accounting treatment adopted by the issuer of a compound financial instrument - a financial liability plus an equity component - is slightly different. The value of the equity component when it is initially recognised is the difference between the fair value of the instrument as a whole, and the fair value of the ‘financial liability’ component. The equity component is not subsequently revalued.
See example at CFM37650.