FASB Embedded Derivatives Interaction of the Requirements of EITF Issue No. 86-28 and Statement 133 Related to Structured Notes Containing Embedded Derivatives

FASB: Embedded Derivatives: Interaction of the Requirements of EITF Issue No. 86-28 and Statement 133 Related to Structured Notes Containing Embedded Derivatives

Derivatives Implementation Group

Statement 133 Implementation Issue No. B24

Title: Embedded Derivatives: Interaction of the Requirements of EITF Issue No. 86-28 and Statement 133 Related to Structured Notes Containing Embedded Derivatives
Paragraph references: 12
Date cleared by Board: December 6, 2000
Date revision posted to website: March 14, 2006
Affected by: FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments
(Revised February 16, 2006)

QUESTION

An entity that issued a structured note that is not eligible to be grandfathered under paragraph 50 of Statement 133 (as amended by FASB Statement No. 137, Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133) determined that the structured note does not meet the definition of a derivative in its entirety but contains an embedded feature that is not clearly and closely related to the host contract and meets the definition of a derivative pursuant to paragraph 6 of Statement 133. Prior to its adoption of Statement 133, the entity applied the consensus in EITF Issue No. 86-28, "Accounting Implications of Indexed Debt Instruments," to the structured note. The entity did not allocate proceeds to the contingent payment feature, and any change in the liability resulting from a change in the relevant index value is recorded as an adjustment of the carrying amount of the debt obligation that is recognized in earnings currently. May the entity consider the criterion in paragraph 12(b) of Statement 133 as not met because the structured note's contingent payment feature is measured based on an index value with changes in that value reported in earnings as they occur and, therefore, avoid accounting for the embedded feature separately?

BACKGROUND

EITF Issue 86-28 addresses a situation in which an entity issues a debt instrument with both a guaranteed and contingent payment. The contingent payment may be linked to the price of a specific commodity (for example, oil) or a specific index (for example, the S&P 500). In some instances, the investor's right to receive the contingent payment is separable from the debt instrument. The issue addresses (1) whether the proceeds should be allocated between the debt liability and the investor's right to receive a contingent payment and (2) the issuer's subsequent accounting for recognition of increases in the underlying commodity or index values.

On item (1) above, the Task Force reached a consensus that, if the investor's right to receive contingent payments is separable, the issuer should allocate the proceeds between the debt instrument and the investor's stated right to receive the contingent payments. On item (2) above, the Task Force reached a consensus that, irrespective of whether any portion of the proceeds is allocated to the contingent payment, as the applicable index value increases such that the issuer would be required to pay the investor a contingent payment at maturity, the issuer should recognize a liability for the amount that the contingent payment exceeds the amount, if any, originally attributed to the contingent payment feature. The liability for the contingent payment feature should be based on the applicable index value at the balance sheet date and should not anticipate any future changes in the index value. When no proceeds are originally allocated to the contingent payment, the additional liability resulting from the fluctuating index value should be accounted for as an adjustment of the carrying amount of the debt obligation. If the index increases and the issuer would be required to establish an additional liability, a majority of the Task Force favored recognizing the increase in the contingent payment as a current expense, but a consensus was not reached. The issue summary indicates that, if the index increases to a level that would require liability accrual, the staff believes the issuer should recognize the contingent payment as additional expense.

Paragraph 12 of Statement 133 states, in part:

   Contracts that do not in their entirety meet the definition of a derivative instrument...may contain "embedded" derivative instruments-implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument....An embedded derivative instrument shall be separated from the host contract and accounted for as a derivative instrument pursuant to this Statement if and only if all of the following criteria are met:
  1. The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract....

  2. The contract ("the hybrid instrument") that embodies both the embedded instrument and the host contract is not remeasured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur.

  3. A separate instrument with the same terms as the embedded derivative instrument would, pursuant to paragraphs 6-11, be a derivative instrument subject to the requirements of this Statement....

RESPONSE

No. The requirement in the Issue 86-28 consensus to recognize a liability for the amount that the contingent payment exceeds the amount, if any, originally attributed to the contingent payment feature satisfies the criterion of paragraph 12(b) that the structured note is not measured at fair value, with changes in value reported in current earnings, and thus does not enable an entity to avoid separating an embedded derivative from a host contract unless a fair value election had been made upon the adoption of Statement 155. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.) Measurement of a structured note’s contingent payment feature based on an “index” value is generally not equal to measurement of the overall hybrid instrument based on fair value because the overall hybrid instrument’s fair value encompasses components of value that are not captured by measuring only the note’s contingent payment feature based on an index value. For example, the hybrid instrument’s fair value would reflect adjustments attributable to interest rate risk (if the structured note bears a fixed rate of interest), credit risk, and liquidity risk. Therefore, structured notes that are not in their entirety measured based on fair value and that contain embedded derivative features must be evaluated under the provisions of paragraphs 12(a) and 12(c) of Statement 133 to determine whether they contain embedded derivatives that must be accounted for separately.

However, the consensus in EITF Issue 86-28 would continue to be applicable to structured notes with contingent payments linked to the price of a specific commodity or index that are grandfathered by paragraph 50 of Statement 133 (as amended by Statement 137), which permits entities not to account separately for embedded derivatives in hybrid instruments issued before January 1, 1998 or January 1, 1999, as elected by the reporting entity.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.