The Financial Accounting Standards Board has released two proposed accounting standards updates related to derivatives and hedging.
The first proposal involves the effect of derivative contract novations on existing hedge accounting relationships. The second proposal, also issued Thursday, pertains to contingent put and call options in debt instruments.
The proposed update on derivative contract novations comes from FASB’s Emerging Issues Task Force. The term novation refers to replacing one of the parties to a derivative contract with a new party. In practice, FASB noted, derivative contract novations may occur for a variety of reasons, including (but not limited to) financial institution mergers, intercompany novations, an entity exiting a particular derivatives business or relationship, an entity managing against internal credit limits, and in response to laws or regulatory requirements.
FASB noted that the derivative instrument that is the subject of a novation may be the hedging instrument in a hedge accounting relationship that has been designated under Topic 815, Derivatives and Hedging, in the FASB Codification.
The issue, according to FASB, is whether a change in the counterparty to a derivative instrument that has been designated as a hedging instrument under Topic 815, in and of itself, results in a requirement to dedesignate that hedge accounting relationship and therefore discontinue the application of hedge accounting. The guidance in Topic 815 is not explicitly clear about the effect on an existing hedg e accounting relationship, if any, of a change in the counterparty to a derivative instrument that is designated as the hedging instrument in an existing hedge accounting relationship, FASB acknowledged.
The existing guidance, which is limited, is also interpreted and applied inconsistently in practice. The proposed changes would apply to all reporting entities for which there is a change in the counterparty to a derivative instrument that has been designated as the hedging instrument under Topic 815. They would clarify that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument und er Topic 815 does not, in and of itself, require dedesignation of that hedge accounting relationship provided that all other hedge accounting criteria continue to be met.
An entity would apply the amendments in this proposed update prospectively to all existing and new hedge accounting relationships in which a change in the counterparty to a derivative instrument occurs after the effective date of the proposed guidance.
FASB is asking for feedback on the proposal. The Emerging Issues Task Force will determine the effective date after it considers stakeholder feedback on the proposed update.
Put and Call Options
The second proposal, on contingent put and call options in debt instruments, also comes from the EITF. Topic 815, Derivatives and Hedging, requires that embedded derivatives be separated from the host contract and accounted for as derivatives if certain criteria are met. One of those criteria is that 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 (the “clearly and closely related” criterion).
The current accounting rules provide specific guidance for assessing whether call (put) options that can accelerate the repayment of principal on a debt instrument meet the clearly and closely related criterion. The guidance says that for contingent call (put) options to be considered clearly and closely related, they can be indexed only to interest rates or credit risk.
However, FASB noted the guidance raised interpretative questions that the Derivatives Implementation Group tried to clarify through implementation guidance in a four-step decision sequence applicable to all call (put) options. The four-step decision sequence requires an entity to consider whether (1) the payoff is adjusted based on changes in an index, (2) the payoff is indexed to an underlying other than interest rate s or credit risk, (3) the debt involves a substantial premium or discount, and (4) the call (put) option is contingently exercisable. Questions have emerged about how the four-step decision sequence interacts with the original guidance for assessing embedded contingent call (put) options in debt instruments.
Two different approaches have developed in practice. Under the first approach, the assessment of whether contingent call (put) options are clearly and closely related to the debt host only requires an analysis of the four-step decision sequence. Under the second approach, an assessment of whether the event that triggers the ability to exercise the call (put) option is indexed only to interest rates or credit risk is required in addition to the four-step decision sequence.
FASB noted those different interpretations may result in different conclusions about whether the embedded call (put) option is clearly and closely related to its debt host, and thus may result in different conclusions about which call (put) options should be bifurcated and accounted for separately as derivatives. The amendments in the proposed accounting standards update are supposed to resolve the diversity in practice resulting from those two views.
The changes in the proposed accounting standards update would clarify the requirements for assessing whether contingent call (put) options that can accelerate the payment of principal on debt instruments are clearly and closely related to their debt hosts. An entity performing the assessment under the proposed amendments would be required to assess the embedded call (put) options solely in accordance with the four-step decision sequence.
The amendments in the proposed update 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 (put) options. An entity would apply the amendments in this proposed update on a modified retrospective basis to existing debt instruments as of the beginning of the fiscal year, and interim periods within that fiscal year, for which the proposed amendments are effective.
If an entity had bifurcated an embedded derivative but would no longer be required to do so as a result of applying the amendments in the proposed update, the carrying amount of the debt host contract and the fair value of the previously bifurcated embedded derivative would become the carrying amount of the debt instrument at the date of adoption.
FASB is asking for feedback on this update as well, and the EITF plans to determine the effective date after it considers stakeholder feedback on the proposed update.
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