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FASB Clarifies Guidance on Embedded Derivative Assessments

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Mar 23rd 2016
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New guidance issued by the Financial Accounting Standards Board (FASB) on March 14 resolves diversity in practice related to assessing embedded contingent call or put options in debt instruments.

Accounting Standards Update (ASU) No. 2016-06, Derivatives and Hedging (Topic 815), Contingent Put and Call Options in Debt Instruments, which is based on a consensus of the FASB Emerging Issues Task Force, clarifies the requirements for assessing whether a contingent call or put option that can accelerate the payment of principal on debt instruments is clearly and closely related to its debt host.

Under the new guidance, an entity performing the assessment is required to analyze the embedded call or put option solely in accordance with a four-step decision sequence.

Topic 815, Derivatives and Hedging, requires that embedded derivatives be separated, or bifurcated, from the host contract and accounted for separately as derivatives if certain conditions are met. One of those conditions is that 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.

“The guidance states that for contingent call (put) options to be considered clearly and closely related, they can be indexed only to interest rates or credit risk,” the FASB said. “However, that guidance raised interpretative questions that the [FASB] 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 rates or credit risk.
  3. The debt involves a substantial premium or discount.
  4. The call or put option is contingently exercisable.

However, two divergent approaches developed in practice, according to the FASB. Under the first approach, entities assessed whether contingent call or put options were clearly and closely related to the debt host using only the four-step decision sequence. Other entities assessed whether the event that triggers the ability to exercise the call or put option is indexed only to interest rates or credit risk.

“Those two approaches, which resulted from different interpretations of the intent of the four-step decision sequence, 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.”

Under the ASU, when a call or 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 FASB said. “The amendments are an improvement to GAAP because they eliminate diversity in practice in assessing embedded contingent call (put) options in debt instruments.”

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

Early adoption is permitted, including adoption in an interim period.

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