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Derivative toolkit: Do I have a derivative? · PwC's accounting podcast

• 0:00
  SPEAKER_02: Thought Leadership from PWC.
• 0:10
  SPEAKER_00: Welcome to PWC's Accounting Podcast.
• 0:13
  SPEAKER_00: I'm Heather Horn.
• 0:15
  SPEAKER_00: Thanks for tuning in to a brand new Toolkit series this month.
• 0:19
  SPEAKER_00: In this series, we take a deep dive each month into a single topic, recapping the basics, but also focusing in on frequently asked questions and judgmental areas.
• 0:30
  SPEAKER_00: This month, we're all about derivatives.
• 0:33
  SPEAKER_00: We'll explore several challenging areas, including definition and scope exceptions, applying the hedge accounting model for debt hedges, dealing with foreign operations, and what you need to know if you have library-based derivatives.
• 0:47
  SPEAKER_03: And I've heard some people, you know, accountants look through very normal transactions and often think through the lens of my first step in looking at almost everything is to ask, is this a derivative contract?
• 1:00
  SPEAKER_01: I mean, read the contracts carefully.
• 1:02
  SPEAKER_01: You know, that's always going to be something.
• 1:03
  SPEAKER_01: You'd be surprised at where some of these things that do ultimately alter cash flows, where they can pop up in a contract.
• 1:11
  SPEAKER_00: My guests today are Brett Dooley and Chris Gerdeau, both from PWC's national office.
• 1:16
  SPEAKER_00: They're going to kick off the series with today's topic.
• 1:19
  SPEAKER_00: I have a derivative, but I don't know it, where we'll be talking about identifying derivatives.
• 1:26
  SPEAKER_00: There's a lot to cover, so let's get started.
• 1:30
  SPEAKER_00: Brett, Chris, thanks so much for joining me today for the first episode in our month of uh podcasts about derivatives.
• 1:37
  SPEAKER_00: And it's perfect first topic, I think, which is something that catches a lot of people off guard.
• 1:44
  SPEAKER_00: Meaning, I have a derivative, but I don't know it.
• 1:47
  SPEAKER_00: Because I think some derivatives are obvious, but there's often times where you may have a derivative, and like the title says, you don't know about it.
• 1:55
  SPEAKER_00: So, Brett, just to kick off this conversation, I thought it'd be helpful to go through the definition of a derivative because obviously that's where this all starts.
• 2:04
  SPEAKER_03: Yeah, I think that definition is important, uh, Heather, because like you said, people often think of the obvious examples when we talk about derivatives, like an option to buy equity securities or an interest rate swap, um, you know, things that are documented on a standard uh derivative contract.
• 2:23
  SPEAKER_03: Um, but the definition in GAAP is much broader than that and can encompass items that a lot of people wouldn't necessarily think of as derivatives.
• 2:31
  SPEAKER_03: Um derivatives can come in many forms.
• 2:34
  SPEAKER_03: A lot of times we see derivatives that are freestanding in their own contracts.
• 2:39
  SPEAKER_03: But as we'll go through today, um sometimes these derivative features can actually be embedded in a non-derivative instrument, and we need to find those and in some cases account for them separately as well.
• 2:52
  SPEAKER_03: So let's start with the actual definition of a derivative.
• 2:56
  SPEAKER_03: Um, a derivative is not defined by the type of instrument that it's in or the contract that it's written on.
• 3:02
  SPEAKER_03: It's defined by meeting three criteria.
• 3:05
  SPEAKER_03: Um, and so the three criteria in the definition of a derivative are one, uh that the contract has an underlying and a notional amount or a payment provision.
• 3:16
  SPEAKER_03: Two, is that it requires no initial net investment or an initial net investment that's smaller than would typically be required for that type of contract or exposure.
• 3:27
  SPEAKER_03: And three, that the contract is able to be net settled.
• 3:31
  SPEAKER_00: All right.
• 3:32
  SPEAKER_00: And so, Brad, I would just echo your first comments in terms of that it's not always obvious you have a derivative.
• 3:39
  SPEAKER_00: And I still vividly remember when FAS 133 was first issued and effective, so this would be around the year 2000, uh, that people weren't aware that power contracts or contracts to buy natural gas would be derivatives because, hey, you're just buying power, so you could could use it, you know, for whatever purpose or deliver it to your customers.
• 3:58
  SPEAKER_00: And I know we're gonna get to some exceptions later, but I think an easy example to think about of something that might not be obvious would be things like commodity contracts.
• 4:09
  SPEAKER_00: And we'll we'll talk about that a little bit more as we run through here, but definitely would encourage people to think and focus on the definition, not on contract form, as you said.
• 4:21
  SPEAKER_00: So, with that said, let's run through the definition in more detail, starting with the first criterion, which would be that you have a the contract has an underlying and has either a notional amount or a payment provision.
• 4:34
  SPEAKER_03: Right.
• 4:35
  SPEAKER_03: So let's start with what's what's an underlying?
• 4:38
  SPEAKER_03: You know, an underlying is just the factor that ultimately determines the settlement amount.
• 4:42
  SPEAKER_03: And that's going to depend on the type of contract or arrangement that we're thinking of.
• 4:47
  SPEAKER_03: Um, in most examples, it's a price or a rate.
• 4:50
  SPEAKER_03: Um, you know, for example, in an interest rate swap, the underlying um is the market interest rate.
• 4:58
  SPEAKER_03: In a contract to purchase an equity security, the underlying may be the the price of the equity security.
• 5:06
  SPEAKER_03: So it's it's the the the um the factor that you're looking at that's going to ultimately determine um the settlement amount of the derivative.
• 5:14
  SPEAKER_03: Um it can also be the occurrence or non-occurrence of an event.
• 5:18
  SPEAKER_03: So I could have a weather-based derivative that um talks about whether the average temperature in a location is above 80 degrees in a month.
• 5:29
  SPEAKER_03: That's gonna ultimately be a yes or no question.
• 5:32
  SPEAKER_03: Um and then that gets to the payment provision.
• 5:34
  SPEAKER_03: Maybe that contract, if that condition um exists, if the underlying has been met, then the payment provision is going to be you know$1,000.
• 5:44
  SPEAKER_03: It's gonna be a fixed amount.
• 5:46
  SPEAKER_03: In a lot of cases, uh, we have a notional amount though, uh, which is gonna be the amount, um, the number of units in the contract.
• 5:53
  SPEAKER_03: So if I'm buying, if I have a forward to buy equity securities, it's gonna be the number of equity securities in your in your power contract or your commodity contract, it's gonna be the amount of the commodity that that you're going to buy.
• 6:06
  SPEAKER_03: But it's important to remember that that notional can be fixed in the number of units, or it could just be a fixed or determinable dollar amount.
• 6:14
  SPEAKER_00: All right, I think that's helpful.
• 6:16
  SPEAKER_00: And I also think, Brett, a key point here is that that price or rate, if you're going back to that part of the definition, it can be either fixed or variable, depending.
• 6:25
  SPEAKER_00: So that's something also to think about as you're looking at these contracts.
• 6:29
  SPEAKER_00: So let's look then at the second part of the definition.
• 6:34
  SPEAKER_00: And this one I think might take a little more explanation.
• 6:37
  SPEAKER_00: So it's saying that the contract requires either no initial net investment or an initial net investment that's smaller than would be required for that type of contract.
• 6:48
  SPEAKER_00: So perhaps before you explain that, we should just say what an initial net investment is or what that really means.
• 6:55
  SPEAKER_03: Think of it just as the amount that you initially transfer for the contract.
• 7:00
  SPEAKER_03: Um, and again, I'll go back to the obvious, um, an obvious derivative if we're talking about an option to buy an equity security.
• 7:09
  SPEAKER_03: Um the the amount that would be required to get that exposure to an equity security would be the price of the equity security.
• 7:20
  SPEAKER_03: And that would be transferred in a cash contract, that would be the amount transferred up front.
• 7:24
  SPEAKER_03: But in an option to buy an equity security, you likely make a payment just for the option premium, which is you know a much smaller amount.
• 7:34
  SPEAKER_03: And so you're getting to what that uh initial cash transfer is and and and comparing that to what what the what the amount would be for the full exposure.
• 7:44
  SPEAKER_03: We get into questions about um the second provision, which is an initial net investment that's smaller than would be required.
• 7:51
  SPEAKER_03: Um I'd say in practice, um people often use a 90%-ish uh threshold to determine uh whether whether they've met that condition.
• 8:02
  SPEAKER_03: In a lot of cases, um you're you're not even you're not close to that that sort of threshold.
• 8:08
  SPEAKER_03: Um, the the amount um uh required for initial net investment and derivative is often well less than that.
• 8:14
  SPEAKER_03: Um and I get I think it's always helpful to think of it in terms of those obvious derivatives, like the equity example that I gave, and then that extrapolates um probably over to some more complex uh examples in practice.
• 8:28
  SPEAKER_00: All right, so then for the third part of the definition, and this one is the third part of the definition and itself has three options sort of within it.
• 8:37
  SPEAKER_00: And I think sometimes it can be the most complicated, and that is that the contract is able to be net settled.
• 8:43
  SPEAKER_00: So again, perhaps we should start by explaining what net settlement is, and then we can talk about the different ways you can get there.
• 8:49
  SPEAKER_03: Right.
• 8:50
  SPEAKER_03: Um, think of think of net settlement as uh when where you're settling the the net value of the contract uh at it at its termination.
• 8:59
  SPEAKER_03: Uh again, in the simplest example, um, to purchase an equity security, uh, a lot of derivatives are just cash settled at the end.
• 9:06
  SPEAKER_03: Uh if the equity security has gone up in value by$5, uh, we're going to net settle that$5 in cash at the end of the contract.
• 9:14
  SPEAKER_03: And that's the first way you can achieve net settlement is just by a pure cash delivery for the gain or loss.
• 9:21
  SPEAKER_03: But there are other forms of net settlement that also meet this condition that aren't just an explicit delivery of cash.
• 9:30
  SPEAKER_03: Um in some cases, uh you can meet this net settlement criteria by being able to net settle through a market mechanism.
• 9:38
  SPEAKER_03: So we're not going to exchange cash.
• 9:40
  SPEAKER_03: However, there's an active and a liquid market that exists so that at either a termination of the derivative or at the uh at the ultimate settlement of the derivative, there is a marketplace where buyers and sellers stand ready to enter into that contract and take over that contract.
• 9:59
  SPEAKER_03: Um, so you can settle it in this exchange via a sale or an assignment or other type of liquidation of the contract.
• 10:06
  SPEAKER_03: Think of it as in if there's a liquid exchange, you're almost in the same position of net settlement or of a cash settlement because you know you can go to that exchange, someone else, another third party will take over that contract and and deliver cash, and then you, as the original owner of the contract, walk away with the same cash you'd have as if you net settled in cash.
• 10:30
  SPEAKER_03: And then the third way you can achieve net settlement is another area where we have lots of questions in practice.
• 10:36
  SPEAKER_03: It's it's when you deliver an asset that's readily convertible to cash.
• 10:41
  SPEAKER_03: And so there are a lot of contracts where you that don't permit net settlement at all.
• 10:47
  SPEAKER_03: There's no cash settlement provisions.
• 10:49
  SPEAKER_03: You're gonna deliver a con a physical asset at the end, um, but that asset may be readily convertible to cash.
• 10:56
  SPEAKER_03: Again, think of in terms of a liquid equity security.
• 11:01
  SPEAKER_03: Um you're put in the position, even if you're gonna receive that physical security at the end of the contract.
• 11:08
  SPEAKER_03: Um, if that contract, if that security itself is readily convertible to cash, you can easily take that security, convert it to cash, and put yourself back in the position almost as if you had received net cash.
• 11:20
  SPEAKER_03: And so um so where you have assets that are readily convertible to cash, they're treated as meeting the net settlement uh condition.
• 11:30
  SPEAKER_03: There's a lot of questions around what is readily convertible to cash, and this is what we struggle with um all the time in practice, um, because some markets may be liquid uh for some types of instruments or commodities and maybe less liquid for other types.
• 11:47
  SPEAKER_03: Sometimes you get into specific grades of commodities where some may meet the definition of um of net settlement of readily convertible to cash and and others, others may not.
• 11:59
  SPEAKER_03: So it's important to understand uh what those um what the provisions of the contract are and what's going to be delivered, as well as um what what market mechanisms or what markets may exist to convert that asset into cash and determine the the liquidity of that market, the cost that would be required to access that market and make that determination uh whether you meet this condition.
• 12:25
  SPEAKER_00: Yeah, and I think to that exact point, Brett, this is probably dealing with commodities where you get the most questions.
• 12:31
  SPEAKER_00: And in particular, you know, you'll have a case where if you were delivering the commodity at one location, maybe there is a very active market and you you would meet this definition and maybe different location not.
• 12:44
  SPEAKER_00: So definitely this is one where you really need to understand your contract.
• 12:48
  SPEAKER_00: And then there are sort of criteria that you can look at to determine if it is considered to be an active market.
• 12:55
  SPEAKER_00: And so often, if you know, it doesn't change, right?
• 13:00
  SPEAKER_00: Like you have an active market today, you're gonna have it tomorrow.
• 13:02
  SPEAKER_00: But we do sometimes see cases where on day one the market's not active, but over time with that contract, that the market becomes active.
• 13:11
  SPEAKER_00: And this is a case where you do have to keep looking at it.
• 13:14
  SPEAKER_00: So you can't say, oh, well, the day I entered into it, the market wasn't active, I'm done.
• 13:19
  SPEAKER_00: Uh so that's just one thing that I have seen in practice where on day one it wasn't, but later the market's devolved more.
• 13:25
  SPEAKER_00: So something you know to keep an eye out.
• 13:27
  SPEAKER_00: And again, if you're dealing with this, there's definitely specific guidance uh to look at.
• 13:32
  SPEAKER_03: There is a there's a lot of guidance.
• 13:34
  SPEAKER_03: Um, but but um as you said, like there's a lot of questions that that exist in practice.
• 13:39
  SPEAKER_03: And ultimately, this is one area of many here where there's some judgments to be made.
• 13:44
  SPEAKER_03: Um and and we understand, like in some cases, different people will reasonably reach different judgments and very similar fact patterns.
• 13:52
  SPEAKER_00: Yes, I think that's definitely also a good reminder to give here uh that you'd want to make sure you're making your own assessment and not just looking maybe at what you see other people doing.
• 14:02
  SPEAKER_00: So we're not gonna dig deeper into that specific definition.
• 14:06
  SPEAKER_00: There is more guidance out there that we've published that you can look at.
• 14:10
  SPEAKER_00: But the other thing where I think this can get complicated is that even with that broad definition, then there are a number of different scope exceptions that the FASBI's given to say, okay, even if you meet the definition, if you meet one of these scope exceptions, you don't have to follow the derivative accounting.
• 14:28
  SPEAKER_00: And I think I jumped in before Brett had a chance to say this.
• 14:32
  SPEAKER_00: But if you conclude it is a derivative, and they was stating things all our listeners would already know, but that asset or liability would be recorded at fair value, and the changes in fair value would be going through earnings, unless, of course, it's a hedge.
• 14:46
  SPEAKER_00: That's uh a topic for another podcast.
• 14:49
  SPEAKER_00: So going back to scope exceptions, Chris, let me bring you into the conversation.
• 14:54
  SPEAKER_00: And what are some of the most common scope exceptions that you see in in practice?
• 15:00
  SPEAKER_01: Sure, Heather.
• 15:01
  SPEAKER_01: I mean, you you're you're right, there's definitely a lot of contracts out there that could meet the definition of a derivative literally.
• 15:10
  SPEAKER_01: And so in order to maybe correct for some unintended consequences and perhaps not to disrupt um business activities too much, there's a number of scope exceptions that have been included into the literature uh in order to sort of correct against those things and not have those contracts be trapped in a derivative and have to be marked to market.
• 15:35
  SPEAKER_01: Um maybe one of the most common examples is what's referred to as the normal purchases and normal sales.
• 15:42
  SPEAKER_01: Uh, you've been mentioning uh a few times commodity contracts, and this is one where uh commodity contracts um are a good example of something for a normal purchase and normal sale.
• 15:54
  SPEAKER_01: Uh if you think about uh a company and entering into a contract uh to purchase or sell non-financial instruments that they're gonna use in the regular course of their business, so maybe it's their inventory or maybe they're a manufacturing company and they need raw materials, some of those contracts could meet the literal definition of a derivative, but it doesn't kind of make sense to have those contracts recorded as a derivative.
• 16:18
  SPEAKER_01: They're really just being used in a production you know way.
• 16:22
  SPEAKER_01: Um but if you kind of work through the uh the definition, I mean, they'll have a notional, which is going to be the amount that's normally being purchased.
• 16:30
  SPEAKER_01: Um, it'll have an underlying, which will be the price of the commodity itself.
• 16:34
  SPEAKER_01: Um there's usually no net investment up front as they usually settled at the end of the um or paid at the end of the settled settlement of the contract.
• 16:44
  SPEAKER_01: Um and from a net settlement, well, they could be um meeting the definition of net settlement, the commodity itself may be readily convertible to cash, or sometimes there's payment provisions or or penalties that are included that could constitute uh a net settlement.
• 17:00
  SPEAKER_01: So I think you can kind of see where a normal contract to purchase a good or or raw material or what have you could meet the definition.
• 17:11
  SPEAKER_01: So um what the standard did is it said, okay, if it's going to be simply used in the normal course of business, you can apply a scope exception and not have to account for those types of contracts as a derivative.
• 17:24
  SPEAKER_00: And I think, Chris, one thing I'd chime in here to add, because this is probably dealing with commodity contracts, probably one of the biggest areas of questions that we receive, is that there is a little more to it than just saying that, you know, I'm going to use in my the normal course of business, you have to be able to start.
• 17:40
  SPEAKER_00: It's probable throughout the term of the contract that you're not going to net settle and otherwise.
• 17:46
  SPEAKER_00: But probably a very key point here is that you do have to document that you are taking this election.
• 17:53
  SPEAKER_00: So you can't just, you know, say, oh, it's normal, I'm going to treat it this way.
• 17:58
  SPEAKER_00: And then, you know, a year later, someone says, Well, why are you doing that?
• 18:01
  SPEAKER_00: You actually have to document that you met all the criteria, and then you can take this exception.
• 18:07
  SPEAKER_00: This is actually not that this is an IFRS podcast, but this is a key difference from guidance under IFRS, where if you meet this, if you meet this own use criteria, which is what they call it, then you have to follow that versus under US GAP, this is an option.
• 18:23
  SPEAKER_00: So just something to highlight.
• 18:25
  SPEAKER_00: And again, if you're dealing with this exception in particular, you will want to look deeper at the criteria and make sure you document that.
• 18:33
  SPEAKER_00: So, Chris, how about other exceptions?
• 18:35
  SPEAKER_00: Uh, what else do we see?
• 18:37
  SPEAKER_01: Sure.
• 18:38
  SPEAKER_01: So another um example of an exception are certain compensation arrangements.
• 18:43
  SPEAKER_01: Um, so if you're familiar with compensation arrangements, um, many of them are accounted for under ASC 718.
• 18:51
  SPEAKER_01: Um, many of those are simply stock options, though.
• 18:54
  SPEAKER_01: And you know, as kind of Brett talked about in the definition of a derivative, um, you know, I think it's you could see where an equity, a stock um option would clearly meet the definition of a derivative.
• 19:06
  SPEAKER_01: And so again, you know, an exception was put into place that would say, okay, if the contract, a compensation arrangement with an employee or or or otherwise is in the scope of 718, then you don't have to worry about the derivative accounting under ASC 815.
• 19:23
  SPEAKER_01: You follow the compensation guidance and account for it as such.
• 19:28
  SPEAKER_01: Maybe somewhat similar to that, there's uh another scope exception uh for own equity.
• 19:34
  SPEAKER_01: Um and so what that is, is a company that's issuing instruments that are both indexed to and expected to be settled in the stock of the company.
• 19:44
  SPEAKER_01: There are exceptions to applying the derivative accounting for those as well.
• 19:49
  SPEAKER_01: Um some of those can be pretty strict though, in that they have to meet very certain criteria.
• 19:54
  SPEAKER_01: Um but if you take a warrant for an example, you know, again, like a stock option, you know, it's gonna have a notional, it'll have the number of shares that it can be exercised into, and the underlying is obviously the price of the share of the company.
• 20:08
  SPEAKER_01: Um you generally don't pay um you know the full price up front on a warrant.
• 20:14
  SPEAKER_01: It may be a small premium, maybe no payment at all, so it wouldn't have an initial net investment.
• 20:21
  SPEAKER_01: Um and net settlement would be simply either you can net share settle, the shares could be readily convertible.
• 20:28
  SPEAKER_01: Sometimes there's cash um settlement features in it too.
• 20:32
  SPEAKER_01: So a warrant would meet the the the um definition of a derivative.
• 20:37
  SPEAKER_01: So what the standard says is that an issuer of those instruments, you know, the company itself, could apply a scope exception, they have to be very careful in thinking about well, what are the variable features within that contract?
• 20:50
  SPEAKER_01: And are those items in the contract that could kind of change or alter the the cash flow or the settlement of those um warrants, um, if they're indexed to the company's stock and they're not leveraged, there's no extraneous factors or anything like that.
• 21:07
  SPEAKER_01: Um that's kind of the first gate in order to apply this scope exception.
• 21:12
  SPEAKER_01: The second is they also have to have the ability um to actually deliver shares, right?
• 21:18
  SPEAKER_01: To to settle in the shares of the company.
• 21:20
  SPEAKER_01: If there are features that the company would be required to actually pay cash or or something else, um then you wouldn't be able to meet the scope exception.
• 21:28
  SPEAKER_01: So it has to be both indexed to the stock, to the equity of the company, and also expected to be settled in that equity.
• 21:37
  SPEAKER_01: Um, those are probably some of the main examples that we see, but there are a few others as well.
• 21:42
  SPEAKER_01: Um, non exchange traded contracts.
• 21:45
  SPEAKER_01: Um, those could be contracts that may be indexed to one of the counterparty sales or service revenues.
• 21:52
  SPEAKER_01: Um, there are scope scope exceptions for that.
• 21:55
  SPEAKER_01: Like you mentioned before, Heather, like you know, you always have to meet the specific criteria for each one.
• 22:00
  SPEAKER_01: Of these, and I won't necessarily go into each one of those because we could probably spend all day doing that.
• 22:04
  SPEAKER_00: Yes.
• 22:05
  SPEAKER_00: Um, but one individual exception, we could probably do an entire podcast.
• 22:10
  SPEAKER_01: Exactly.
• 22:10
  SPEAKER_01: Um, but yeah, just a few others.
• 22:12
  SPEAKER_01: Um, insurance contracts, some insurance contracts have scope exceptions, loan commitments um may have scope exceptions, um, and and security trades, you know, just kind of regular buying and selling of securities that have a regular settlement feature, um, those have certain scope exceptions too.
• 22:30
  SPEAKER_01: So just a few other things to look for.
• 22:32
  SPEAKER_00: Let me ask you a question because I made the point at the beginning about normal purchases and sales, that that's like an opt-in.
• 22:39
  SPEAKER_00: So if you don't opt-in, then you follow the derivative guidance, you follow ASC 815.
• 22:45
  SPEAKER_00: And I don't work with these other ones as much.
• 22:49
  SPEAKER_00: And so, but I is my understanding correct that for these other ones, it's not an opt-in.
• 22:54
  SPEAKER_00: If you meet the criteria for the exception, you don't follow derivative accounting, or is there some optionality as well with these other exceptions?
• 23:03
  SPEAKER_01: Yeah, I wouldn't say that there's a lot of optionality per se.
• 23:06
  SPEAKER_01: I think what you have to do though is you have to make sure you meet the criteria.
• 23:09
  SPEAKER_01: And so from a documentation perspective, sometimes you may need to document how you meet the criteria.
• 23:16
  SPEAKER_01: And if perhaps you can't do that, then you might not be able to apply the scope exception.
• 23:21
  SPEAKER_01: But it's not simply, oh yes, I meet all the criteria, here's why I meet it, but I decide not to.
• 23:26
  SPEAKER_00: Yep.
• 23:26
  SPEAKER_00: Okay, that I think that's a helpful point.
• 23:28
  SPEAKER_00: And I think also a good reminder to people if you are dealing with one of these, that you want to make sure you look at all these exceptions and make sure whether they do or don't apply.
• 23:38
  SPEAKER_00: Because if it should apply and you shouldn't follow derivative accounting, you definitely want to make sure you're not.
• 23:43
  SPEAKER_03: So I think that's really important in this area, Heather, because a lot of times in GAP, we think of exceptions to a rule as like fairly narrow and nuanced.
• 23:53
  SPEAKER_03: But in in derivatives, this is where an area where they set a really, really broad definition of a derivative.
• 24:00
  SPEAKER_03: And then these scope exceptions are similarly really broad.
• 24:03
  SPEAKER_03: You know, there's a scope exception for insurance contracts.
• 24:06
  SPEAKER_03: So like it's almost like a whole industry, right?
• 24:10
  SPEAKER_03: An exception to a derivative.
• 24:11
  SPEAKER_03: So there's a lot of areas where where you go through this broad definition, you almost anything can be a derivative, and then these scope exceptions are really important.
• 24:20
  SPEAKER_00: Yeah, I think that's a good reminder.
• 24:21
  SPEAKER_00: And actually, Brett, that made me think, you know, people who deal with derivatives a lot will remember the derivatives implementation group and you know, the thousand-page book of interpretations, but many, many interpretations on the scope exceptions.
• 24:34
  SPEAKER_00: So definitely, you know, something that is broad and that you want to make sure you're following, or, you know, you can equally uh make an error by calling something a derivative when it really shouldn't be.
• 24:46
  SPEAKER_01: Well, and Heather, you know, it's it's it's one of those areas where this standard has been out, what, almost 20 years, I think.
• 24:53
  SPEAKER_01: Yeah, 20 plus maybe more.
• 24:55
  SPEAKER_01: And you would think that all these things are kind of settled, right?
• 24:58
  SPEAKER_01: But even in the last year or two, there have been some tweaks to some of the scope exceptions as an example, right?
• 25:03
  SPEAKER_01: So this is an ongoing thing as new activities are determined, as you know, new contracts come into place.
• 25:09
  SPEAKER_01: Again, constantly thinking about is there an unintended unintended consequence here, you know, or maybe a disruption to a business activity that's not meant by applying the derivative.
• 25:20
  SPEAKER_01: I think you'll continue to see if it the scope exceptions are are need to be tweaked going forward.
• 25:25
  SPEAKER_01: So it's kind of an always stay tuned as well.
• 25:27
  SPEAKER_01: It's not a, hey, think about, you know, I I thought about this years ago, I don't have to, you know, think about it again.
• 25:33
  SPEAKER_00: I think that is a great reminder because I do agree this is a place where you can't just assume or presume that what you've done in the past always applies.
• 25:42
  SPEAKER_00: Um the good reminder there.
• 25:45
  SPEAKER_00: Brett, let me rewind though to something that you said earlier, because you when we were talking about at the beginning of the podcast, you mentioned this idea that you could have a freestanding derivative, so a contract that in its entirety is a derivative, or you could have an embedded derivative.
• 26:03
  SPEAKER_00: And we skipped over that pretty quickly, but it's obviously a key part uh when you're dealing with the definitions.
• 26:08
  SPEAKER_00: So can you kind of walk through what we mean when we we talk about those two two different concepts?
• 26:16
  SPEAKER_03: Sure.
• 26:16
  SPEAKER_03: Um, and I think this is this is often where this title of the podcast comes into play, where there's features embedded in a contract that may not be a derivative in its entirety, but it still requires um separate accounting because you have you have derivative features.
• 26:31
  SPEAKER_03: So I think we've already covered what the freestanding derivative you know in a contract that meets those um that definition with the three criteria.
• 26:40
  SPEAKER_03: Um but there there may be situations where you have provisions in a contract that don't meet the definition of a derivative in it in the entirety, but the provisions when you separate them out do meet the definition.
• 26:54
  SPEAKER_03: And so when you think about trying to identify these, you need to understand and think through all the provisions in the contract, where there is variability in payments under the contract, and whether those provisions that could change either the timing or amount of cash flows they may meet need to be uh evaluated as a potential feature.
• 27:18
  SPEAKER_03: Remember, the goal here is that the FASB didn't want um want um there to be situations where you could take a derivative provisions and just jam it into another contract and avoid the mark-to-market um uh treatment that they thought was appropriate for uh for derivatives.
• 27:37
  SPEAKER_03: And so the most common examples of host contracts that contain embedded derivatives, I'd say are debt and equity hosts.
• 27:44
  SPEAKER_03: Um let's start with a simple example of convertible debt.
• 27:48
  SPEAKER_03: So this is debt that can be settled often at the option of the holder, either in a fixed amount of cash or in an amount of cash or through the delivery of an equity of an equity security.
• 28:04
  SPEAKER_03: So the debt contract is not um like typical debt because it has this conversion feature that gives exposure to the the price of the underlying equity.
• 28:15
  SPEAKER_03: In many cases, the debt host contract isn't a derivative in its entirety, because remember, we talked about that net investment test.
• 28:22
  SPEAKER_03: And you know, in the debt contract, the investor you know put put forth the money up front, and so it does uh have an initial net investment that that's significant.
• 28:35
  SPEAKER_03: Uh, but that conversion option, we need to think through whether it's an embedded derivative.
• 28:39
  SPEAKER_03: Um, that and when you separate out that conversion option and those features, the conversion option itself may meet the definition of a derivative and therefore uh may need to be uh separated.
• 28:52
  SPEAKER_03: In some cases, a preferred stock uh can be an equity host contract that has certain conversion or redemption options that accelerate the settlement of cash.
• 29:04
  SPEAKER_03: And we see other contracts that may have embedded derivatives from lease contracts to insurance contracts, which often get a scope exception.
• 29:12
  SPEAKER_03: But we need to be looking at these contracts for these embedded features.
• 29:17
  SPEAKER_03: It's also important to remember that just the presence of an embedded derivative doesn't necessarily dictate the accounting.
• 29:24
  SPEAKER_03: Um the there's again three criteria.
• 29:28
  SPEAKER_03: We always keep talking about three criteria and derivative.
• 29:31
  SPEAKER_00: So it comes in threes, yeah, absolutely.
• 29:32
  SPEAKER_03: To think about whether you need to bifurcate an embedded derivative.
• 29:36
  SPEAKER_03: Um and the the first is is that hybrid instrument that contains the embedded derivative is not otherwise carried at fair value with changes in fair value through PL.
• 29:46
  SPEAKER_03: So in the convertible debt example, if someone has elected the fair value option on that on that convertible debt, they don't need to go through and and separate, try to separate out embedded derivatives because the whole contract is already marked to market through PNL.
• 30:02
  SPEAKER_03: The second criteria is whether the embedded feature is clearly and closely related to the host contract.
• 30:09
  SPEAKER_03: Um, think of the economics of the host contract itself versus the economics of this embedded feature.
• 30:15
  SPEAKER_03: Um take my the conversion option example, it's generally would not be considered clearly and closely related to a debt host contract because the changes in price of equity aren't related to any of the features of the debt contract itself.
• 30:33
  SPEAKER_03: However, there may be embedded interest rate features in a debt instrument that by themselves may be considered a derivative, for example, a prepayment option.
• 30:45
  SPEAKER_03: But that prepayment option may be considered clearly and often is considered clearly and closely related to the underlying debt, and so isn't going to be separated.
• 30:55
  SPEAKER_03: So again, you're looking for a feature that is separate and apart from the typical features of that host contract.
• 31:03
  SPEAKER_03: And then third, um, the third criteria for separation is that that embedded feature meets a definition of a derivative on its own.
• 31:12
  SPEAKER_03: The same three criteria we talked about earlier.
• 31:15
  SPEAKER_03: Um but the the interesting feature here is that that net investment uh criteria that I talked about needs to be viewed separately from separately between this this embedded feature and the host contract as a whole.
• 31:33
  SPEAKER_03: So again, if you meet all of these three criteria for bifurcation, then that embedded derivative needs to be separated from the host contract and follow mark mark-to-market derivative accounting uh for that embedded feature.
• 31:46
  SPEAKER_00: Okay, then definitely a lot of concepts there.
• 31:48
  SPEAKER_00: And I think we've maybe overwhelmed our audience a little bit because just understanding the definition of derivative is complicated, and then getting into this idea of bifurcating an embedded derivative.
• 32:00
  SPEAKER_00: What I think may be helpful to kind of walk through and cement this would be to run through some of the common examples.
• 32:07
  SPEAKER_00: So, Chris, what types of things do you see in practice where we could kind of think some of this through?
• 32:13
  SPEAKER_01: Sure, Heather.
• 32:14
  SPEAKER_01: Um, well, I think Brett's already mentioned quite a few of them.
• 32:17
  SPEAKER_01: Uh, actually, you know, talked about debt with conversion features.
• 32:20
  SPEAKER_01: I mean, that's pretty clear.
• 32:22
  SPEAKER_01: Um, preferred stock may have uh puts or calls in them that could be um an embedded derivative.
• 32:29
  SPEAKER_01: I mean, a lot of the things, if you think about um a contract, you know, anything that's gonna alter the cash flows uh of that contract or alter the settlement features of that contract could potentially be uh an embedded derivative.
• 32:43
  SPEAKER_01: I think Brett also mentioned contingent interest features could be in either a debt or a preferred stock uh type contract, to be honest with you.
• 32:52
  SPEAKER_01: Um, these are the types of things that that you would look at in those kind of um instruments.
• 32:59
  SPEAKER_01: Um but you know, in addition to that, there's there's um you know a few other things.
• 33:05
  SPEAKER_01: Um maybe an example to talk through would be um like a contract to purchase raw materials or supplies.
• 33:12
  SPEAKER_01: You know, we talked before about how that could potentially have a scope exception um and be um treated as a normal purchase, normal sale.
• 33:21
  SPEAKER_01: So if the contract in and of itself does not meet the definition of a derivative or qualifies for a scope exception, there could still be features within that contract that you need to think about could that be an embedded derivative that needs to be bifurcated?
• 33:34
  SPEAKER_01: Um and so that could be price caps or flaws.
• 33:37
  SPEAKER_01: You know, those adjust the cash flows since the amount will not vary solely based on the con on the host contract.
• 33:43
  SPEAKER_01: Um variable prices tied to a specific index.
• 33:47
  SPEAKER_01: Um foreign currency swaps, if they're settled in a different currency other than the functional currency of the two parties, you know, you may not think that uh uh contract to purchase raw materials could have a foreign currency swap in it.
• 34:00
  SPEAKER_01: Um but it could if if the you know foreign currency um that's used within the contract is not one of the functional currencies of one of the parties to it.
• 34:10
  SPEAKER_01: So you know there's there's a few um examples for you.
• 34:15
  SPEAKER_01: But I think that um maybe there's a couple of key takeaways there.
• 34:19
  SPEAKER_01: You know, you always have to understand the broad definition of a derivative, um, and you have to use it to analyze a really broad range of contracts and transactions, and not just the contract itself, but all the features within that contract that could alter uh the timing nature of the cash flows or the settlement features.
• 34:37
  SPEAKER_01: Um so after you consider the contract, you consider the provisions, um, you know, you think about everything there, I think you realize it's pretty complex.
• 34:46
  SPEAKER_01: So you might want to get some help from some of the experts too, because um these things are you know can be tricky at times.
• 34:54
  SPEAKER_00: So I definitely think that's some helpful summaries and you hit on a key point there, which is what big picture would you say you're looking for?
• 35:03
  SPEAKER_00: So put aside the definition, because obviously once you've identified a feature or an embedded or a contract itself that might be a derivative, then you can run through the definition.
• 35:13
  SPEAKER_00: But Brett, if as you are thinking about the types of contracts that may have derivatives in them or that are derivatives in the entirety, any sort of broad uh context that you could give.
• 35:26
  SPEAKER_00: I have a few thoughts, but just curious from your experience, how you kind of could look at a contract and say, Oh, I'm positive that one wouldn't have an embedded derivative, or oh, this one might be worth looking at.
• 35:40
  SPEAKER_03: That's an interesting question, Heather.
• 35:41
  SPEAKER_03: You're you and you're talking to someone who sees derivatives everywhere in the world.
• 35:46
  SPEAKER_00: Fair enough.
• 35:47
  SPEAKER_00: I think most financial instruments people do.
• 35:49
  SPEAKER_03: And I've heard some people, um, you know, accountants look look through very normal transactions and often think through the lens of my first step in looking at almost everything is to ask, is this a derivative contract?
• 36:01
  SPEAKER_03: Even when I'm selling goods, like is that a derivative contract?
• 36:05
  SPEAKER_03: And and often, often it is.
• 36:07
  SPEAKER_03: Um, it's sort of an uncomfortable place to start from looking at every arrangement that you look look at as a derivative contract.
• 36:14
  SPEAKER_03: I think of generally you're looking for variability of cash flows that seem different or unusual compared to um, you know, typical transactions.
• 36:24
  SPEAKER_03: So you're you're looking for changes in timing of cash flows.
• 36:28
  SPEAKER_03: Um we've given examples where very vanilla contracts like we think of every day, like insurance contracts and sales and purchase contracts can still have an embedded derivative in them or or meet the definition of a derivative.
• 36:43
  SPEAKER_03: But it's those kinds of features with variable cash flows that I think you need to start out with as your first trigger.
• 36:50
  SPEAKER_03: But you were saying you had some things in mind.
• 36:51
  SPEAKER_03: What were you?
• 36:52
  SPEAKER_00: Well, no, I mean, I think you kind of hit it and Chris did too a little bit.
• 36:57
  SPEAKER_00: It's it's almost like you are looking for variability, something where there could be variable cash flows where your ultimate settlement is different than maybe the fair value at the point of your settlement, at least with commodities.
• 37:10
  SPEAKER_00: That's you know what we think about because you're agreeing right now, perhaps to pay a fixed price for a commodity in the future.
• 37:17
  SPEAKER_00: That price may have changed and that you still lock this in.
• 37:20
  SPEAKER_00: So you have some value there.
• 37:23
  SPEAKER_00: I think that's big picture.
• 37:26
  SPEAKER_00: Just again, is there it's almost like if there is a fair value to this contract where there's some amount that it would have value to you or to the counterparty, that's what you're looking for.
• 37:36
  SPEAKER_00: But I I actually agree overall, Brett, with your your first point, which is there's not like a rule of thumb here.
• 37:43
  SPEAKER_00: You just have to look at your contract and make sure you're kind of using this as a screen to say, like, do you meet these criteria even either in the entirety or for some for some element to the contract?
• 37:57
  SPEAKER_00: Chris, any other thoughts from you if you're dealing with you know companies or um engagement teams that have maybe aren't as familiar with some of this derivative guidance?
• 38:07
  SPEAKER_01: Um, I mean, read the contracts carefully.
• 38:10
  SPEAKER_01: You know, that's always gonna be something.
• 38:11
  SPEAKER_01: You you'd be surprised at where some of these things that do ultimately alter cash flows, where they can pop up in a contract.
• 38:19
  SPEAKER_01: You know, it's not it's not like the contract's gonna say, okay, here's where the derivative is, or here's where the embedded derivative is or whatever the case is.
• 38:27
  SPEAKER_01: I mean, they could be anywhere within the contract.
• 38:29
  SPEAKER_01: So make sure you're carefully reading the contracts.
• 38:31
  SPEAKER_00: I think that is always great advice.
• 38:33
  SPEAKER_00: So thank you for bringing that one up.
• 38:35
  SPEAKER_00: All right, then.
• 38:36
  SPEAKER_00: So a couple of last questions to wrap things up.
• 38:38
  SPEAKER_00: So, Brett, anything that uh Chris made the point earlier, this guidance has been around a long time, and yet we continue to see changes in interpretation.
• 38:47
  SPEAKER_00: So, what are you seeing from a standard setting perspective that people should be aware of?
• 38:52
  SPEAKER_03: Um, the the FASB has a project on their research agenda regarding ESG and this definition of a derivative that we talked about.
• 39:00
  SPEAKER_03: Um, there are a number of debt instruments with embedded ESG features where if a specific target is met or not met uh related to often environmental goals, um, that the interest rate or uh will change on the debt or or some other feature would be triggered.
• 39:23
  SPEAKER_03: And when we go through this definition of a derivative, uh many have concluded that these ESG features actually meet the definition of a derivative because they have an underlying and there's a payment provision through a step up on the on the debt.
• 39:37
  SPEAKER_03: Um and this is an example where um many financial statement users have expressed that that information marking to market that ESG feature is not helpful information.
• 39:47
  SPEAKER_03: So I think the FSB is going to take a look at that and think about the appropriateness of the of this broad definition we have.
• 39:55
  SPEAKER_03: Is there a new scope exception that needs to be created to deal with these types of um I'll call them non-exchange traded features that that um that exist in practice that that may not be useful to account for as a derivative?
• 40:12
  SPEAKER_00: All right, I think that's definitely helpful and something to keep an eye on because it'll be interesting to see where the FASB goes with this.
• 40:20
  SPEAKER_00: So that hits the of my primary questions, I guess, in terms of places to go look for more information, because this is definitely a case where I feel like we've just been able to skim the surface.
• 40:31
  SPEAKER_00: Highly recommend uh to our listeners that you check out the derivatives and hedging guide.
• 40:36
  SPEAKER_00: And then in addition, if you're dealing with commodity contracts, the power and utilities guide actually has quite a lot of information on notionals, uh net settlement, normal purchase and normal sales, a lot in the context of power contracts, but some of it is also applicable more broadly, so that could be helpful.
• 40:56
  SPEAKER_00: So, Chris and Brett, really appreciate you joining today.
• 40:59
  SPEAKER_00: I think just to wrap things up, we're recording this right before the 4th of July.
• 41:03
  SPEAKER_00: It's being released right after the 4th of July.
• 41:06
  SPEAKER_00: And I know for me, I still have such a soft spot for this holiday because when I was a kid in Wisconsin, we had the whole neighborhood parade, sparklers, fireworks, huge picnic, you know, the whole sort of quintessential American experience.
• 41:21
  SPEAKER_00: Uh, just curious if anything in particular you guys like about the 4th of July.
• 41:26
  SPEAKER_00: So, Brett, I'll go to you first.
• 41:28
  SPEAKER_03: Um I I also grew up in Wisconsin, so I always look forward to the family barbecues and some good bratwurst uh on the on the 4th of July and some fireworks at night.
• 41:38
  SPEAKER_00: All right, good.
• 41:39
  SPEAKER_00: And Chris, how about you?
• 41:40
  SPEAKER_01: Well, I would have to say that I grew up in New York and we have barbecues there too, Brett.
• 41:44
  SPEAKER_01: So it's it's not just a Wisconsin thing, but uh no, you know, it's it's it's always for me, it's always a good time.
• 41:51
  SPEAKER_01: It's in the summer, and so it's just uh a nice way to celebrate with my family and and you know enjoy everything about them and everything about um you know what the what the holidays for and celebrating us.
• 42:04
  SPEAKER_00: All right.
• 42:05
  SPEAKER_00: Well, it sounds like we all have sort of similar approach to this holiday.
• 42:08
  SPEAKER_00: So I'm glad to hear you guys are are also fans, and um, as always, really appreciate you joining me today.
• 42:14
  SPEAKER_00: And thanks for all the insight.
• 42:16
  SPEAKER_03: Thanks, Alex.
• 42:18
  SPEAKER_00: That's our show for today.
• 42:20
  SPEAKER_00: Join me this Thursday for a special update on what's going on in the economy and the outlook for the rest of 2022.
• 42:27
  SPEAKER_00: And if you're listening to this the week of July 4th, I'd be remiss if I didn't wish you a happy independence day.
• 42:34
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• 42:50
  SPEAKER_00: From thought leadership at PWC, I'm Heather Horn.
• 42:54
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