Quiz: Embedded Derivatives and Disclosure

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4 questions to check your understanding of the chapter “Embedded Derivatives and Disclosure”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   How does ASC 815-15 in US GAAP link the decision to separate an embedded derivative to the type of host contract?

   1. A.If the host is a financial asset, the derivative is not separated; only when it is not a financial asset are the three conditions applied
   2. B.Whether the host is a debt instrument, an equity instrument, a lease, or anything else, the same three conditions apply
   3. C.The three conditions apply only when the host is a debt instrument; for equity instruments and leases, the derivative is not separated
   4. D.If the host is a debt instrument, the derivative is separated without any conditions; for equity instruments and leases, the three conditions apply
   Answer and explanation

   Answer: B

   ASC 815-15 requires bifurcation only when all three conditions are met, whether the host is a debt instrument, an equity instrument, a lease, or anything else. It does not set a different starting point by type of host.

   Not separating the derivative when the host is a financial asset, and classifying the whole contract instead, is the starting point in International Financial Reporting Standard (IFRS) 9. ASC 815-15 does not separate a derivative embedded in a debt instrument without conditions either.

   Learn more: Embedded Derivatives

2. Question 2

   Which statement correctly describes the accounting after an embedded derivative is bifurcated under ASC 815-15?

   1. A.The embedded derivative is measured at fair value with changes recognized in profit or loss, and the host is accounted for under the standard that applies to it
   2. B.Both the embedded derivative and the host are measured at fair value on an ongoing basis, with changes in both recognized in profit or loss
   3. C.The embedded derivative is measured at fair value with changes recognized in other comprehensive income even without a hedge designation, and the host is accounted for under the standard that applies to it
   Answer and explanation

   Answer: A

   Under ASC 815-15, the bifurcated embedded derivative is measured at fair value, with changes recognized in profit or loss. The host is accounted for under the standard that applies to it, so it is not continuously measured at fair value.

   Changes in a bifurcated embedded derivative are recognized in other comprehensive income only when it is designated as the hedging instrument in a qualifying cash flow hedge or a hedge of a net investment in a foreign operation.

   Learn more: Embedded Derivatives

3. Question 3

   As a hypothetical example, Company T has swap A (fair value 80 million yen) and swap B (fair value −50 million yen) with Bank M under a single master netting arrangement, and has posted no collateral. If none of the other conditions for offsetting (an intention to settle net, and a mechanism for doing so) is met, how is this presented on the balance sheet under International Financial Reporting Standards (IFRS), as of the March 2012 commentary?

   1. A.Asset of 30 million yen, liability of 0 yen
   2. B.Asset of 80 million yen, liability of 30 million yen
   3. C.Asset of 80 million yen, liability of 0 yen
   4. D.Asset of 80 million yen, liability of 50 million yen
   Answer and explanation

   Answer: D

   IFRS does not allow offsetting on the existence of a master netting arrangement alone. The rights under such an arrangement can be used only after an event such as a default. This example meets no other condition either, so A is presented gross as an asset of 80 million yen and B as a liability of 50 million yen.

   The fair values of the two swaps total 80 − 50 = 30 million yen however they are presented. An asset of 30 million yen and a liability of 0 yen is the net presentation, which US GAAP lets you choose for derivatives under a master netting arrangement if the remaining conditions are met, whether or not the company intends to offset.

   Learn more: Japanese GAAP vs IFRS vs US GAAP

4. Question 4

   As a hypothetical example, in Company U's offsetting disclosure under IFRS 7, derivative liabilities have a gross amount recognized of 5.0 billion yen and an amount offset of 1.0 billion yen. Financial instruments not offset but subject to an enforceable master netting arrangement total 0.8 billion yen, and the financial collateral pledged is 2.5 billion yen. What is the net amount disclosed (the net amount presented on the balance sheet, less the amounts subject to the arrangement)?

   1. A.4.0 billion yen
   2. B.3.2 billion yen
   3. C.0.7 billion yen
   4. D.1.5 billion yen
   Answer and explanation

   Answer: C

   The net amount presented on the balance sheet is 5.0 − 1.0 = 4.0 billion yen. The amounts not offset but subject to the arrangement are the financial instruments and the financial collateral together, 0.8 + 2.5 = 3.3 billion yen, which does not exceed the 4.0 billion yen presented on the balance sheet. The net amount disclosed is 4.0 − 3.3 = 0.7 billion yen.

   4.0 billion yen stops at the net amount presented on the balance sheet. 3.2 billion yen subtracts only the 0.8 billion yen of financial instruments from 4.0 billion yen. It forgets the collateral. 1.5 billion yen is 5.0 − 1.0 − 2.5, which forgets to subtract the 0.8 billion yen of financial instruments.

   Learn more: Disclosures in the Notes