Unreliable measurement on fair value of hybrids instruments.

A financial derivatives is a contract that is derives its value based on an underlying

asset. Underlying asset is term used to describe the financial instrument. As stated by Timothy
E. Lynch, a derivative can be defined as, “a financial instruments whose value depends on or
is derived from a secondary source such as an underlying bond, currency or commodity,”
(Lynch, 2011). Derivatives are financial instruments designed to achieve a certain economic
result when an underlying security, index, interest rate, commodity, or other financial
instrument move in prices (Lil E. Crawford, 1997).

A few years ago, the innovation of derivative instrument has led to the development
of hybrid securities, which have characteristics of both debt and equity and often are a
combination of traditional and derivative financial instruments. Embedded derivative is the
component of hybrid financial instruments as a contract feature that have similar characteristic
with derivative. For instances of the embedded derivative, a convertible bond is a hybrid
instrument because it is comprises of a debt security, which is refer to the host security,
combined with an option to convert the bond to shares of common stock. As stated by (Faulds,
2009), “an embedded derivative is a contract feature modifying other contractual cash flows
in response to a financial index”. The focus of derivative is on the change of the value, while
the embedded derivative is about the modification of cash flow, even if the modifications are
neutral to the value.

Many organisation use embedded derivation a risk management practices. Under FAS
133, the embedded derivative is valued using fair value principles. As derivative strategies
have become more commonplace, risk regulation has tightened. According to (Lil E. Crawford,
1997), to make decision about the fair values used, qualitative characteristic such as relevancy
can help to generates useful information. Fair market values, in general, provide relevant
information. Measuring all derivatives at their fair values would not only result in visibility on
the financial statements, but would provide users with information on the magnitude of gains
or losses at that point in time as a result of entering into these financial contracts.

Currently, (FASB, 1994) requires that fair values of these instruments be included in
disclosures. If the constituents believe in the efficient market hypothesis, then as long as the
information is available, the market will respond accordingly. But if the constituents truly
believe the market is efficient, then why were they so opposed to recognizing expense in the
financial statements for the fair value of stock options, but were willing to accept footnote
disclosure of the impact of this expense on net income? Disclosure of fair values is not
sufficient; therefore, these values should be reported in the financial statements.

Comparability is an important characteristic of accounting information. Current

authoritative guidance, or lack of guidance, has resulted in less than desirable comparability.
Derivatives not specifically covered are analogized to existing guidance and that guidance is
inconsistent. As a result, similar instruments could be accounted for differently. In addition,
current accounting guidance is complex and may not be applied as it was intended. The
proposed approach is relatively simple and applies to all derivatives, even those yet to be
developed. The incompleteness and complexity of current guidance has been addressed and
therefore comparability should increase.

The basis of any embedded derivative, and consequently of any separation according
to (Lil E. Crawford, 1997), is a contractual cash flow that is modified by a change in a market
factor. A first step in identifying an embedded derivative is, therefore, to identify contractual
cash flows sensitive to changes in market factors (derivatives on the other hand do not require
a change in cash flows but rather a change in value) This makes it easier to identify embedded
derivatives. This PG refers to those cash flows as “embedded derivative cash flows”. Not all
embedded derivative cash flows are based on embedded derivatives. The identifiable
modifying condition within a combined contract is also needed, with the result that this
modifying condition is the embedded derivative. For example, the benefits under a unit-linked
(variable) contract are usually determined in response to the fair value of the units (a market
factor) and are, therefore by definition, embedded derivative cash flows. This benefit is not a
consequence of a modifying condition, since that variation of cash flows is the nature of the
contract itself. There is no embedded derivative as a basis of the embedded derivative cash
flow. Affected cash flows subject to a correlated financial risk are considered together on a
combined basis. If the impact of the market factor on that net cash flow is significant, then
the net cash flow is an embedded derivative cash flow. Relevant effects on cash flows include
those (1) that can be directly triggered by market factors (e.g., contractual terms linking cash
flows directly to market factors); (2) that can be affected by compound market factors; (3)
where other factors not related to an underlying combine with a market factor to affect cash
flows (double-triggers); and (4) where market factors indirectly influence counter-parties in
executing options.
References
FASB. (1994). Statement of Financial AccountingStandards No. 119 Disclosure about Derivative
Financial Instruments. Financial Accounting Standards Board.

Faulds, T. G. (2009). Embedded Derivatives and Derivatives under International Financial Reporting
Standards. Canada: Canadian Institute of Actuaries.

Lil E. Crawford, A. C. (1997). Using an Accounting for Derivatives: An internantional concern. Journal
of International Accounting, Auditing & Taxation, 6(l): 111-121, 112.

Lynch, T. E. (2011). Derivatives: A Twenty-First Century Understanding. Loyola University Chicago

Law Journal 43.