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Derivatives Implementation Group

Statement 133 Implementation Issue No. C6

QUESTION

In a transfer of financial assets accounted for as a financing under FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, is a derivative instrument that arises because of the transfer subject to the scope of Statement 133 if it does not itself serve as an impediment to achieving sale accounting but sale accounting could not be achieved due to an impediment that is unrelated to the derivative?

BACKGROUND

Paragraph 10(f) of Statement 133 provides a scope exception for a derivative instrument that serves as an impediment to sale accounting under Statement 140. For example, if an entity transfers financial assets that are not readily obtainable by a transferee and holds a call option on those transferred assets, the call option would not be subject to Statement 133 because the call option served as an impediment to sale accounting. Paragraph 284 in the basis for conclusions of Statement 133 further explains the need for that scope exception. It states:

     The existence of certain derivatives affects the accounting for the transfer of an asset or a pool of assets. For example, a call option that enables a transferor to repurchase transferred financial assets that are not readily available would prevent accounting for that transfer as a sale. The consequence is that to recognize the call option would be to count the same thing twice. The holder of the option already recognizes in its financial statements the assets that it has the option to purchase. Thus those types of derivatives are excluded from the scope of this Statement.

Examples of derivatives that may arise in transfers of financial assets accounted for as financings under Statement 140 are call options retained by the transferor on securities transferred and interest-rate swaps that convert the fixed-rate nature of financial assets transferred to variable-rate assets.

RESPONSE

A derivative held by a transferor that relates to assets transferred in a transaction accounted for as a financing under Statement 140, but which does not itself serve as an impediment to sale accounting, is not subject to Statement 133 if recognizing both the derivative and either the transferred asset or the liability arising from the transfer would result in counting the same thing twice in the transferor's balance sheet. However, if recognizing both the derivative and either the transferred asset or the liability arising from the transfer would not result in counting the same thing twice in the transferor's balance sheet, the derivative should be accounted for in accordance with Statement 133.

Examples applying that approach in situations in which the transferor accounts for the transfer as a financing are presented below.

• If a transferor transfers financial assets but retains a call option on those assets, the condition in paragraph 9(c) of Statement 140 may be satisfied because the assets transferred are readily obtainable; however, the transfer may fail the isolation condition in paragraph 9(a) because of significant continued involvement by the transferor. In that example, because the transferor is required to continue to recognize the assets transferred, recognition of the call option on those assets would effectively result in recording the assets twice. Therefore, the derivative is not subject to the scope of Statement 133.

• In the situation described above, the transferor may have sold to the transferee a put option. Exercise of the put option by the transferee would result in the transferor repurchasing certain assets that it has transferred, but which it still records as assets in its balance sheet. Because the transferor is required to recognize the borrowing, recognition of the put option would result in recording the liability twice. Therefore, the derivative is not subject to the scope of Statement 133.

• A transferor may transfer fixed-rate financial assets to a transferee and guarantee a floating-rate return. If the transfer is accounted for as a sale and an interest-rate swap is entered into as part of the contractual provisions of the transfer, the transferor records the interest-rate swap as one of the financial components. In that case, the interest-rate swap should be accounted for separately in accordance with Statement 133. However, if the transfer is accounted for as a financing, the transferor records on its balance sheet the issuance of floating-rate debt and continues to report the fixed-rate financial assets; no derivative is recognized under Statement 133.

• In a securitization transaction, a transferor transfers $100 of fixed-rate financial assets and the contractual terms of the beneficial interests incorporate an interest-rate swap with a notional principal of $1 million. If the transfer is accounted for as a sale and the interest rate swap is entered into as part of the contractual provisions of the transfer, the transferor identifies and records the interest-rate swap as one of the financial components. In that case, the interest-rate swap would be accounted for separately in accordance with Statement 133. However, if the transfer is accounted for as a financing, the transferor records in its balance sheet a $100 floating-rate borrowing and continues to report the $100 of fixed-rate financial assets. In this example, because the liability is leveraged, requiring computation of interest flows based on a $1 million notional amount, the liability (which does not meet the definition of a derivative in its entirety) is a hybrid instrument that contains an embedded derivative—such as an interest rate swap with a notional amount of $999,900. That embedded derivative is not clearly and closely related to the host contract under paragraphs 12 and 13(b) of Statement 133 because it could result in a rate of return on the counterparty's asset that is at least double the initial rate and that is at least twice what otherwise would be the then-current market return for a contract that has the same terms as the host contract and that involves a debtor with credit quality similar to the issuer's credit quality at inception. Therefore, the derivative must be recorded separately under paragraph 12 of Statement 133.

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.