FASB standard unifies embedded derivative practices

FASB’s guidance in Accounting Standards Update No. 2016-06, Derivatives and Hedging (Topic 815): Contingent Put and Call Options in Debt Instruments, brings new detail to the “clearly and closely related” criterion as related to embedded derivatives.

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.

U.S. 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 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 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.

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.