The Financial Accounting Standards Board’s Emerging Issues Task Force has issued an accounting standards update for contingent put and call options in debt instruments.

FASB noted that the existing standards for derivatives and hedging require embedded derivatives to be separated from a host contract and accounted for separately as derivatives if certain criteria are met. One of those criteria is if the economic characteristics and risks of the embedded derivatives are not clearly and closely related to the economic characteristics and risks of the host contract.

U.S. GAAP already provides 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, that guidance raised some questions of interpretation that FASB’s Derivatives Implementation Group tried to clarify through implementation guidance in a four-step decision sequence for all call (put) options. The 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 rates or credit risk, (3) the debt involves a substantial premium or discount, and (4) the call (put) option is contingently exercisable.

However, new 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, FASB noted. 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.

The problem is those two approaches could result in different conclusions about whether the embedded call (put) option is clearly and closely related to its debt host, and could even lead to different conclusions about which call (put) options should be bifurcated and accounted for separately as derivatives.

The amendments in the new accounting standards update are supposed to resolve the diversity in practice from those two approaches. They 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. According to FASB, an entity performing the assessment under the amendments is required to assess the embedded call (put) options solely in accordance with the four-step decision sequence. The amendments clarify which steps are required when assessing whether the economic characteristics and risks of call (put) options are clearly and closely related to the economic characteristics and risks of their debt hosts, which is one of the criteria for bifurcating an embedded derivative. Consequently, when a call (put) option is contingently exercisable, an entity does not have to assess whether the event that triggers the ability to exercise a call (put) option is related to interest rates or credit risks. The amendments promise to eliminate the diversity in practice in assessing embedded contingent call (put) options in debt instruments.

For public business entities, the amendments take effect for financial statements issued for fiscal years beginning after Dec. 15, 2016, and interim periods within those fiscal years. For entities other than public business entities, the amendments are effective for financial statements issued for fiscal years beginning after Dec. 15, 2017, and interim periods within fiscal years beginning after Dec. 15, 2018.

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