ASC 815-25: Embedded Derivatives Bifurcation Transactions & Journal Entries

ASC 815-25: Embedded Derivatives Bifurcation Transactions & Journal Entries

Posted In | ASC Education | Gridlex Academy

Accounting Standards Codification (ASC) 815-25, part of the larger ASC 815 Derivatives and Hedging topic, specifically addresses the accounting treatment for embedded derivatives in financial instruments. This article will provide an overview of the ASC 815-25 guidance, explain the concept of bifurcation, and demonstrate the application of this guidance through an example using journal entries.

 

1. ASC 815-25: Embedded Derivatives

Embedded derivatives are derivative instruments that are embedded within a financial instrument or a contract. These instruments may be separated from their host contracts and accounted for as standalone derivatives if they meet specific criteria laid out in ASC 815-25.
 

The three criteria for bifurcation are:

a. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract.
 

b. The hybrid (combined) instrument is not measured at fair value with changes in fair value recognized in earnings.
 

c. A separate instrument with the same terms as the embedded derivative would meet the definition of a derivative instrument.
 

2. Bifurcation Transaction

If an embedded derivative meets the criteria for separation, it is bifurcated from the host contract, which means the embedded derivative is treated as a separate financial instrument. The embedded derivative is then measured at fair value, with changes in its fair value recognized in earnings.
 

3. Journal Entries: Bifurcation Transaction Example

Suppose a company, XYZ Corp, issues a 5-year convertible bond with a face value of $1,000,000 that pays a 6% annual coupon. The bond is convertible into the company's common stock at a conversion rate of 100 shares for each $1,000 face value of the bond. The fair value of the bond (without the conversion option) is $950,000, and the fair value of the embedded conversion option is $100,000.
 

Journal entries for the bifurcation transaction
 

1. Record issuance of the convertible bond:

Dr. Cash $1,000,000

Cr. Bonds Payable $950,000

Cr. Conversion Option (Embedded Derivative) $50,000

 

2. Record annual coupon payment:

Dr. Interest Expense $60,000

Cr. Cash $60,000

 

3. Record fair value adjustment of the conversion option (assume it increased by $20,000):

Dr. Conversion Option (Embedded Derivative) $20,000

Cr. Gain on Embedded Derivative $20,000

 

4. Record conversion of the bond into common stock (assume the bond has been fully converted):

Dr. Bonds Payable $950,000

Dr. Conversion Option (Embedded Derivative) $70,000

Cr. Common Stock $1,000,000

Cr. Gain on Bond Conversion $20,000
 

ASC 815-25 provides guidelines for the accounting treatment of embedded derivatives in financial instruments. Bifurcation transactions separate embedded derivatives from their host contracts, allowing them to be accounted for as standalone instruments. Proper application of the guidance ensures accurate financial reporting and improves the transparency of an organization's financial statements.