FASB clarifies embedded derivative standards

The guidance in Accounting Standards Update 2016-06, Derivatives and Hedging (Topic 815), Contingent Put and Call Options in Debt Instruments, is intended to resolve accounting practices that have diverged. The new standard is the result of a project undertaken by FASB’s Emerging Issues Task Force.

U.S. GAAP requires embedded derivatives to be separated from the host contract and accounted for separately as derivatives if certain criteria are met. One of those criteria 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. This is called the “clearly and closely related” criterion.

GAAP states that call or put options that can accelerate the repayment of principal on a debt instrument meet the clearly and closely related criterion if they can be indexed only to interest rates or credit risk. The standard issued Monday clarifies that an entity is required to assess the embedded call or put options solely in accordance with a four-step decision sequence that was created by FASB’s Derivatives Implementation Group.

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.
• The call or put option is contingently exercisable.

The new standard clarifies that 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 or put option is related to interest rates or credit risks. Through this clarification, FASB intends to eliminate diversity in practice in which some entities were assessing whether the event that triggers the ability to exercise the call or put option is indexed only to interest rates or credit risk in addition to the four-step decision sequence.

The amendments take effect for public business entities for financial statements issued for fiscal years beginning after Dec. 15, 2016, and interim periods within those fiscal years. For 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.

FASB is permitting early adoption, including adoption in an interim period.

—Ken Tysiac (ktysiac@aicpa.org) is a JofA editorial director.