FASB Embedded Derivatives Application of Statement 133 to a Not-for-Profit Organizations Obligation Arising from an Irrevocable Split-Interest Agreement

FASB: Embedded Derivatives: Application of Statement 133 to a Not-for-Profit Organization’s Obligation Arising from an Irrevocable Split-Interest Agreement

Derivatives Implementation Group

Statement 133 Implementation Issue No. B35

Title: Embedded Derivatives: Application of Statement 133 to a Not-for-Profit Organization’s Obligation Arising from an Irrevocable Split-Interest Agreement
Paragraph references: 5, 10(c), 12
Date cleared by Board: April 9, 2002
Date latest revision posted to website: February 28, 2007
Affected by: FASB Statements No. 155, Accounting for Certain Hybrid Financial Instruments, and No. 157, Fair Value Measurements
(Revised September 15, 2006)

QUESTION

When does a not-for-profit (NFP) organization’s obligation arising from an irrevocable split-interest agreement contain an embedded derivative instrument that should be bifurcated and accounted for as a derivative instrument pursuant to the requirements of paragraph 12 in Statement 133?

BACKGROUND

General

Split-interest agreements are agreements in which donors enter into trusts or other arrangements under which NFP organizations receive benefits that are shared with other beneficiaries. A typical split-interest agreement has two components—a lead interest and a remainder interest. The lead interest is the right to the benefits (cash flows or use) of the transferred assets during the term of the agreement, which generally starts upon the signing of the agreement and terminates either (1) after a specified number of years (period-certain) or (2) upon the occurrence of a certain event, commonly either the death of the donor or the death of the lead interest beneficiary (life-contingent). The remainder interest is the right to receive all or a portion of the assets remaining at the end of the agreement’s term.

Chapter 6 of the AICPA Audit and Accounting Guide, Not-for-Profit Organizations (NFP Guide), addresses the accounting for irrevocable split-interest agreements by NFP organizations. In an irrevocable split-interest agreement, the donor may give the NFP organization the right to control the contributed assets by either (1) naming them trustee of the trust holding the assets or (2) granting them the right to hold the assets as general assets of their organization. In either case, the assets are recorded on the NFP organization’s statement of financial position at their fair value when received. The NFP organization’s obligation to make specified cash payments to a designated beneficiary or to convey the remaining assets to the donor or the donor’s beneficiary is recognized as a liability1 and measured based on the present value of the future expected payments to the beneficiary. Although the NFP organization’s liability may coincidentally be equal to fair value, that liability is not measured at fair value under generally accepted accounting principles (GAAP) because the NFP Guide requires that the discount rate used in estimating the present value of future expected payments to the beneficiary be determined at the time the contribution is initially recognized and is not revised subsequently.

Perceived Conflict with Statement 133

Paragraph 5 of Statement 133 indicates that its scope includes NFP organizations, but the Statement does not specifically address the application of its provisions to the accounting for NFP organizations’ obligations arising from split-interest agreements. Nevertheless, Statement 133 could apply to certain liabilities of NFP organizations arising from split-interest agreements.

Paragraph 6 of Statement 133 specifies the characteristics that a contract must have to be considered a derivative instrument in its entirety under that Statement. Paragraph 12 addresses contracts that do not in their entirety meet the definition of a derivative instrument in paragraph 6 but may contain provisions that constitute an embedded derivative instrument that could warrant separate accounting. (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. However, Statement 155 does not apply to hybrid financial instruments that are described in paragraph 8 of FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, which include insurance contracts as discussed in FASB Statements No. 60, Accounting and Reporting by Insurance Enterprises, and No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, other than financial guarantees and investment contracts. 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.) Paragraph 12 states, in part, that an embedded derivative instrument shall be separated from the host contract and accounted for as a derivative instrument 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 derivative 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. (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)

The accounting for the liability in an irrevocable split-interest agreement under the NFP Guide could be in conflict with the accounting under Statement 133 as amended if that liability contains an embedded derivative that meets the criteria in paragraph 12 of Statement 133 requiring separate accounting for that derivative or if the fair value election is made pursuant to Statement 155.

Two General Types of Structures

General Structure of a Lead Trust for an NFP Organization: Assets such as cash or shares of stock are contributed by the donor to the control of the NFP organization (either through the NFP organization’s role as trustee of a trust holding the assets, or directly by the NFP organization holding the assets as general assets of their organization). The NFP organization receives periodic cash payments (the lead interest) that are either a fixed dollar amount or a specified percentage of the fair value of the assets as of the beginning of each period. (Note: Some of the assets may need to be liquidated in order to make the required payments.) At the termination of the agreement, the remaining assets revert to the donor or the donor’s beneficiary (the remainder interest). During the term of the agreement, the NFP organization has a liability for the remainder interest. The NFP organization’s liability for its obligation to the donor or the donor’s beneficiary is based in part on the fair value of the assets.

General Structure of a Remainder Trust for an NFP Organization: Assets such as cash or shares of stock are contributed by the donor to the control of the NFP organization (either through the NFP organization’s role as trustee of a trust holding the assets, or directly by the NFP organization holding the assets as general assets of their organization). The NFP organization (or the trust) makes periodic payments to the donor or the donor’s beneficiary that are either a fixed dollar amount or a specified percentage of the fair value of the assets during the term of the agreement. (Some of the assets may need to be liquidated to make the payments.) At the termination of the agreement, the remaining assets revert to the NFP organization. During the term of the agreement, the NFP organization has a liability for the lead interest. If the lead interest payments to the donor or the donor’s beneficiary are based on a specified percentage of the fair value of the assets, the NFP organization’s liability for its obligation to the donor or the donor’s beneficiary is based on the fair value of the contributed assets.

Two aspects of the split-interest agreement’s payment terms for the lead interest—whether the payments are a fixed or variable cash amount and whether the agreement is period-certain or life-contingent—affect the accounting treatment for the NFP organization’s liability for the payment or payments to the donor or the donor’s beneficiary. Paragraph 10(c) of Statement 133 notes that, generally, contracts of the type that are within the scope of FASB Statements No. 60, Accounting and Reporting by Insurance Enterprises, No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, and No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, are not subject to the requirements of Statement 133, because payment of benefits is a result of an identified insurable event, such as the death of an identified individual (mortality risk). Paragraph 7 of Statement 97 indicates that mortality risk is present if, under the terms of an annuity contract, the enterprise is required to make payments contingent upon the continued survival of a specific individual or group of individuals.

RESPONSE

The NFP organization’s liability for its obligation to the donor or the donor’s beneficiary under an irrevocable split-interest agreement should be analyzed to determine whether it qualifies for the exception in paragraph 10(c), in which case that liability would not be subject to the requirements of Statement 133. For example, if the obligation is solely life-contingent (that is, contingent upon the survival of an identified individual, in which case the payments are made only if the individual is alive when the payments are due), that obligation would qualify for the exception in paragraph 10(c). That conclusion is consistent with the guidance to Question 4 in Statement 133 Implementation Issue No. B25, "Deferred Variable Annuity Contracts with Payment Alternatives at the End of the Accumulation Period." If the NFP organization’s liability for its obligation under the split-interest agreement does not qualify for the exception in paragraph 10(c) because the agreement is not solely life-contingent, the NFP organization must determine whether that liability meets the definition of a derivative in its entirety under paragraph 6 or whether it contains an embedded derivative instrument that could warrant separate accounting under paragraph 12 unless a fair value election is made pursuant to Statement 155.

The NFP organization’s liability for its obligation under a split-interest agreement would typically not meet the definition of a derivative instrument in its entirety because it would not meet the criterion in paragraph 6(b). That criterion requires the contract to have no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. In contrast, the initial net investment for the liability recognized for typical split-interest agreements is its fair value (generally measured at the present value of the estimated future payments). If the NFP organization’s liability for its obligation under the split-interest agreement does not in its entirety meet the definition of a derivative instrument in paragraph 6, that liability must be analyzed to determine whether it contains provisions that constitute an embedded derivative instrument that warrants separate accounting under paragraph 12. Generally, the liability representing an obligation under a split-interest agreement contains an embedded derivative that warrants separate accounting if the payments are variable and the agreement is period-certain (rather than life-contingent) unless a fair value election is made pursuant to Statement 155. The following examples, although not all-inclusive, provide an understanding of the applicability of paragraph 12 to various split-interest agreements.

Example 1: Remainder Trust (period-certain, fixed payments) [also known as a Charitable Remainder Annuity Trust]
Shares of common stock are contributed to the control of the NFP organization, who is required to pay the donor or the donor’s beneficiary an annual fixed cash payment for 20 years, after which time the remaining shares revert to the NFP organization. During the term of the agreement (20 years), the NFP organization has a liability that does not require bifurcation of an embedded derivative. Since the periodic cash payment is a fixed dollar amount, the liability has no underlying and, thus, does not meet the criterion in paragraph 6(a) of the definition of a derivative instrument. Because there is no underlying, there is also no embedded derivative that warrants separate accounting under paragraph 12.

Example 2: Remainder Trust (period-certain, variable payments) [also known as a Charitable Remainder Unitrust]
Shares of common stock are contributed to the control of the NFP organization, who is required to make 20 annual cash payments to the donor or the donor’s beneficiary that are equal to a specified percentage of the fair value of the assets as of the beginning of each annual period. After the 20 payments have been made, the remaining shares will revert to the NFP organization. During the term of the agreement (20 years), the NFP organization has a liability that must be bifurcated because it contains an embedded derivative instrument that warrants separate accounting unless a fair value election is made pursuant to Statement 155. Under paragraph 12, the liability represents a hybrid instrument that is composed of a debt host contract and an embedded equity-based derivative that is not clearly and closely related to the debt host and that would meet the definition of a derivative if it were freestanding. That is, it has an underlying (price of shares) and a notional amount (number of shares in the trust at the beginning of each annual period), it satisfies the no-or-smaller initial net investment characteristic in paragraph 6(b), and it would meet the net settlement characteristic in paragraph 6(c) (because each annual payment is adjusted for the effect of the equity-based derivative). That analysis is consistent with the analysis under paragraph 185 of Statement 133 for equity-indexed debt. (The debt host represents the liability for the series of 20 annual payments that would be required based on the assumption that the fair value of the common stock does not change over the 20-year period. The embedded equity-based derivative relates to the increase or decrease in each of the 20 annual payments due to changes in the fair value of the common stock.)

Example 3: Remainder Trust (life-contingent, variable or fixed payments)
Shares of common stock are contributed to the control of the NFP organization, who is required to make annual cash payments to the donor or the donor’s beneficiary that are either a fixed dollar amount or a specified percentage of the fair value of the assets at the beginning of each annual period until the death of the donor or the donor’s beneficiary, upon which time the remaining shares will revert to the NFP organization. During the term of the agreement, the NFP organization has a liability that is not bifurcated because it is solely life-contingent and thus qualifies for the exception in paragraph 10(c).

Example 4: Remainder Trust (period-certain-plus-life-contingent, fixed payments)
Shares of common stock are contributed to the control of the NFP organization, who is required to pay the donor or the donor’s beneficiary an annual fixed cash payment for the longer of the beneficiary’s remaining life or a specified period. The remaining shares then revert to the NFP organization. During the term of the agreement, the NFP organization has a liability that, for purposes of applying Statement 133, must be analyzed as consisting of two separate liabilities: one liability relating to the period-certain cash payments and a second liability relating to the possible additional cash payments that are contingent upon the beneficiary living beyond the end of the period-certain payments. The NFP organization’s liability does not require the bifurcation of any embedded derivative because the portion of the liability related to the fixed period-certain payments has no underlying, and the portion of the liability related to the possible life-contingent payments qualifies for the exception in paragraph 10(c).

Example 5: Remainder Trust (period-certain-plus-life-contingent, variable payments)
Shares of common stock are contributed to the control of the NFP organization, who is required to pay the donor or the donor’s beneficiary an annual cash payment equal to a specified percentage of the fair value of the assets at the beginning of each annual period for the greater of the beneficiary’s remaining life or a specified period. The remaining assets revert to the NFP organization. During the term of the agreement, the NFP organization has a liability that, for purposes of applying Statement 133, must be analyzed as consisting of two separate liabilities: one liability relating to the period-certain cash payments and a second liability relating to the possible additional cash payments that are contingent upon the beneficiary living beyond the end of the period-certain payments. Statement 133 requires that the equity-based derivative embedded in the portion of the liability related to the period-certain variable cash payments be bifurcated from a debt host contract (consistent with the analysis in Example 2). The equity-based derivative embedded in the portion of the liability related to the possible life-contingent cash payments that can occur after the end of the specified period is not subject to Statement 133 because it qualifies for the exception in paragraph 10(c).

Example 6: Lead Trust (period-certain, fixed or variable payments)
An NFP organization receives cash from a donor, which is invested by the NFP organization in common equity securities. The donor designates the organization as lead beneficiary. The NFP organization receives an annual cash payment of either a fixed amount or a specified percentage of the fair value of the investment amount at the beginning of each annual period for a specified period of time. After that time, the remaining assets revert to the donor or the donor’s beneficiary. During the term of the agreement, the NFP organization has a liability that must be bifurcated. Under paragraph 12, the liability represents a hybrid instrument that is composed of a debt host contract and an embedded equity-based derivative that is not clearly and closely related to the debt host and that would meet the definition of a derivative if it were freestanding. That is, it has an underlying (price of shares) and a notional amount (number of shares at the beginning of each annual period), it satisfies the no-or-smaller initial net investment characteristic in paragraph 6(b), and it would meet the net settlement characteristic in paragraph 6(c). Regardless of whether the lead interest payments are fixed or variable, the value of the liability representing the remainder interest—the assets remaining at the end of the agreement that will be paid to the donor or the donor’s beneficiary—is affected by changes in the equity value, thus requiring the equity-based derivative to be bifurcated unless a fair value election is made pursuant to Statement 155. That analysis is consistent with the analysis under paragraph 185 of Statement 133 for equity-indexed debt.

Example 7: Lead Trust (life-contingent, fixed or variable payments)
An NFP organization receives cash from a donor, which is invested by the NFP organization in common equity securities. The donor designates the organization as lead beneficiary. The NFP organization receives an annual cash payment of either a fixed dollar amount or a specified percentage of the fair value of the investment amount at the beginning of each annual period until the death of the donor or the donor’s beneficiary, at which time the remaining assets revert to the donor or the donor’s beneficiary. During the term of the agreement, the NFP organization has a liability that is not subject to Statement 133 because the remainder interest liability relates to a single payment whose amount and timing is life-contingent and thus qualifies for the exception in paragraph 10(c).

Example 8: Lead Trust (period-certain-plus-life-contingent, variable or fixed payments)
An NFP organization receives cash from a donor, which is invested by the NFP organization in common equity securities. The donor designates the organization as lead beneficiary. The NFP organization receives an annual cash payment for either a specified percentage of the fair value of the assets at the beginning of each annual period or a fixed dollar amount. That cash payment is made for the greater of the beneficiary’s (or the donor’s) remaining life or a specified period. After that time, the remaining assets revert to the donor or the donor’s beneficiary. During the term of the agreement, the NFP organization has a liability that is not subject to Statement 133 because, unlike the liability in Example 5, the period-certain aspect of the liability cannot be separated from the life-contingent aspect of the liability (because there is only one payment whose timing and value are affected by mortality risk). Thus, the remainder interest liability relates to a single payment whose amount and timing is life-contingent and thus qualifies for the exception in paragraph 10(c). (If payment occurs only when the beneficiary (or donor) is alive, such as in an agreement where the period is for the lesser of the beneficiary’s (donor’s) remaining life or a specified period, then every payment is life-contingent and qualifies for the exception in paragraph 10(c).) It should be noted that if during the terms of a greater-of-period-certain-or-life-contingent agreement, the beneficiary dies prior to the end of the period-certain terms in the agreement, that change in circumstance eliminates the life-contingent aspect of the contract. Thus, the agreement is now only a period-certain agreement and mirrors the agreement outlined in Example 6, requiring bifurcation of the embedded derivative.

Other Split-Interest Agreements When the Contributed Assets Are Other Than Equity Securities

Some split-interest agreements may involve the gift of corporate or U.S. government debt securities, or other securities that are not equity. In determining whether or not those split-interest agreements contain an embedded derivative, the same analysis should be applied as that given in the above examples and as outlined in paragraph 12 of Statement 133. The notion of clearly and closely related, as defined in paragraph 12(a), shall involve an assessment of the economic characteristics and risks associated with the non-equity securities in relation to the economic characteristics and risks of the NFP organization’s debt host contract. Generally, because of the differences in credit risk, the change in the fair value of corporate bonds (based on that corporation’s credit and interest rate risk) will not be clearly and closely related to the change in the economic characteristics and risks of the NFP organization’s debt host contract. Thus, an embedded derivative requiring bifurcation and separate accounting for the embedded derivative would exist unless a fair value election is made pursuant to Statement 155.

Other Split-Interest Agreements When the NFP Organization Does Not Have Control of the Contributed Assets

Some NFP organizations are parties to split-interest agreements that are similar to those outlined above but involve a third party who maintains control of the donor’s contributed assets. The NFP organization does not have an obligation to pay either the remainder or lead interest to the designated beneficiary, as that responsibility remains with the third party who maintains control of the assets (thus, the NFP organization does not recognize a liability). However, the NFP organization does have an asset and contribution revenue representing their entitlement to the lead interest payments or the remainder interest, as stipulated in the agreement. In accordance with the NFP Guide, the NFP organization should recognize its beneficial interest in those assets by debiting Beneficial Interest in Split-Interest Agreement and crediting Temporarily Restricted Contribution Revenue, at fair value. Subsequent changes in the fair value of the beneficial interest are recognized in the statement of activities. Thus, under paragraph 12 of Statement 133, the embedded derivative in the above contract would not be bifurcated, as the criterion under subparagraph 12(b) is not met.

EFFECTIVE DATE

The effective date of the implementation guidance in this Issue for each reporting entity is the first day of its first fiscal year beginning after June 15, 2002. Restatement of previously issued financial statements is not required.


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1The use of the term liability in this Issue is consistent with the use of that term in the NFP Guide. This Issue does not address whether or not the obligation is a liability or a form of minority interest.


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.