In this video, we walk through 5 BAR practice questions teaching about identifying the characteristics of derivatives. These questions are from BAR content area 2 on the AICPA CPA exam blueprints: Technical Accounting and Reporting
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Identifying the Characteristics of Derivatives
In financial reporting, correctly identifying a derivative—and determining whether it is freestanding or embedded—is essential for accurate recognition and measurement in the financial statements. A derivative is a financial instrument whose value changes based on an underlying variable, requires little or no initial investment, and is settled at a future date. This definition covers instruments such as options, forwards, futures, and swaps, as well as derivatives embedded within other contracts.
Freestanding vs. Embedded Derivatives
A freestanding derivative exists independently and can be traded or transferred on its own. Examples include a call option on a company’s stock or a currency futures contract. These instruments are separate from any host contract, making their identification straightforward.
An embedded derivative, on the other hand, is a component of a larger financial instrument—known as the host contract—that causes some of the contract’s cash flows to vary based on changes in an underlying variable. For example, a bond that pays interest linked to the price of gold contains an embedded derivative because the interest payment depends on an external market factor.
Key Characteristics to Identify
To determine if an instrument is a derivative, accountants look for three characteristics:
- Underlying – A reference point, such as a stock price, interest rate, or commodity value, that drives the derivative’s value.
- Notional Amount or Payment Provision – The quantity tied to the derivative, such as the number of shares or units.
- Little or No Initial Net Investment – Unlike traditional investments, derivatives typically require a minimal upfront payment.
Example in Practice
Consider an equity call option giving the holder the right to purchase 2,500 shares of Company X at $72 per share in six months. Here:
- The underlying is the share price of Company X ($72).
- The notional amount is 2,500 shares.
- The initial net investment could be the premium paid, such as $0 if issued as part of a larger arrangement.
- The settlement amount would be the share price multiplied by the notional amount if exercised, e.g., $72 × 2,500 = $180,000.
This is a freestanding derivative because it exists independently and can be traded without any host contract.
Embedded Derivative Example
Suppose a company issues a five-year bond where annual interest payments increase if the market price of silver rises above a certain threshold. The host instrument is the bond, and the silver-linked feature is the embedded derivative. The embedded derivative must be separated and accounted for at fair value if it meets specific criteria under accounting standards.
Why Identification Matters
Correctly identifying and classifying derivatives ensures compliance with accounting rules such as ASC 815 or IFRS 9. Misclassification could lead to misstated earnings, incorrect risk disclosures, and regulatory issues. Beyond compliance, understanding these instruments is vital for analyzing how financial risk is managed within a business.
In short, knowing how to spot the underlying, notional amount, initial investment, and settlement terms—and determining whether a derivative is freestanding or embedded—forms the foundation for accurate financial reporting.
