FASB Clarifies How to Separate Embedded Derivatives

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By Denise Lugo

Aug. 6 – The Financial Accounting Standards Board issued a proposal to clarify a portion of the guidance for assessing embedded contingent call or put options in debt instruments.

Two divergent approaches have developed that can result in different conclusions about which call or put options should be separated and accounted for as derivatives, said FASB.

The proposal, issued Aug. 5, clarifies that a four-step decision sequence should be used for assessing whether contingent call or put options that can accelerate the payment of principal on debt instruments are “clearly and closely related” to their debt hosts.

Four Steps

The four-step decision sequence was provided by a Derivatives Implementation Group (DIG), after questions were raised about how to interpret “the clearly and closely related” criterion for separating embedded derivatives, which is required under Topic 815, Derivatives and Hedging.

Topic 815 requires that embedded derivatives be separated from the host contract and accounted for as derivatives if certain criteria are met.

One criteria is that the “economic characteristics and risks” of the embedded derivative are “not clearly and closely related” to those of the host contract.

The four-step sequence requires an entity to consider whether:

• the payoff is adjusted based on changes in an index;

• the payoff is indexed to an underlying other than interest rates or credit risk;

• the debt involves a substantial premium or discount; and

• the call or put option is contingently exercisable.

 

Modified Retrospective Approach

The proposed rules would apply to all entities that are issuers of or investors in debt instruments—or hybrid financial instruments that are determined to have a debt host—with embedded call or put options, the ASU states.

If finalized, entities would have to use a modified retrospective approach as of the beginning of the fiscal year and interim periods within that fiscal year for which the rules are effective.

Furthermore, a reporting entity would have a one-time option to irrevocably elect to measure a debt instrument affected by the proposed rules in its entirety at fair value with changes in fair value recognized in earnings, according to a summary of the rules.

The guidance was initially cleared by the FASB's task force unit June 18.

FASB said it's seeking comments by Oct. 5, 2015, on the proposal, which is titled, Derivatives and Hedging (Topic 815), Contingent Put and Call Options in Debt Instruments, a consensus of the FASB Emerging Issues Task Force.

To contact the reporter on this story: Denise Lugo in Norwalk, Conn., at dlugo@bna.com

To contact the editor on this story: Laura Tieger Salisbury at lsalisbury@bna.com

For a copy of the board's handout, including how to submit comments go to: http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176166248141