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FASB Addresses Derivative Contract Novations in New Standard

Mar 16th 2016
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The Financial Accounting Standards Board (FASB) issued a new standard on March 10 that determined that the novation of a derivative contract in a hedge accounting relationship does not, in and of itself, require dedesignation of that hedging relationship.

The new guidance was developed by the FASB’s Emerging Issues Task Force.

The term “novation” refers to replacing one of the parties to a derivative instrument with a new party. Derivative instrument novations occur for various reasons, including financial institution mergers, intercompany transactions, and in response to laws or regulatory requirements.

The current guidance in Topic 815, Derivatives and Hedging, is not clear about the effect on an existing hedging relationship of a change in the counterparty to a derivative instrument that has been designated as a hedging instrument. That guidance has also been interpreted and applied inconsistently in practice.

“Questions were raised about whether a change in the counterparty to a derivative instrument, in and of itself, is considered to be a ‘termination’ of the original derivative instrument in the context of the hedge accounting guidance in Topic 815,” the FASB said. “Similarly, questions were raised about whether the counterparty to the derivative instrument represents a ‘critical term’ of a hedging relationship. The answers to those questions affect the determination of whether the novation of a derivative instrument that has been designated as the hedging instrument in an existing hedging relationship results in a requirement to dedesignate that hedging relationship and, therefore, discontinue the application of hedge accounting.”

Accounting Standards Update (ASU) 2016-05, Derivatives and Hedging (Topic 815), Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships, clarifies that the change in the counterparty does not, in and of itself, represent a termination of the original derivative instrument or a change in the critical terms of the hedging relationship.

As a result, the hedging relationship can continue if all of the other hedge accounting criteria are met.

The new guidance goes into effect for public business entities for fiscal years beginning after Dec. 15, 2016, and interim periods within those fiscal years. For all other entities, the guidance takes effect for fiscal years beginning after Dec. 15, 2017, and interim periods within fiscal years beginning after Dec. 15, 2018. Early adoption is permitted, including early adoption in an interim period.

An entity has the option to apply the amendments in the ASU on either a prospective basis or a modified retrospective basis.

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