FASB Transition Provisions Indexed Debt Hedging Equity Investment

FASB: Transition Provisions: Indexed Debt Hedging Equity Investment

Derivatives Implementation Group

Statement 133 Implementation Issue No. J13

Title: Transition Provisions: Indexed Debt Hedging Equity Investment
Paragraph references:

50, 52

Date cleared by Board: December 6, 2000

QUESTION

Prior to the date of initial application of Statement 133, an issuer considered a debt's embedded equity-indexed payment provision as a hedge of a common stock investment. At initial application, the equity-based derivative embedded in the indexed debt instrument is accounted for separately upon adoption of Statement 133 (including those circumstances in which the reporting entity elects separate accounting under paragraph 50). What is the impact of the Statement 133 transition provisions and can the issuer designate the separated embedded derivative in a hedging relationship on a going-forward basis?

BACKGROUND

Statement 133 defines derivative instruments based on their characteristics; the resulting definition includes certain instruments that were not previously separately accounted for as derivatives. Therefore, prior to the initial application of Statement 133, those instruments were not designated in hedging relationships because they were not accounted for as derivatives. Those circumstances raise implementation questions regarding the application of paragraph 52 to the resultant transition adjustment.

Company A owns 10,000 shares of XYZ common stock that are classified as available-for-sale securities in accordance with FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. The original cost of the securities is $100,000. The shares have appreciated in value such that on January 2, 1999 the market value is $1,000,000. Therefore, in accordance with Statement 115, Company A has recorded a credit to other comprehensive income (OCI) for $900,000 (ignoring any deferred taxes for simplification). Wishing to monetize the appreciation of the XYZ shares, Company A issues a debt obligation on January 2, 1999 that is indexed to the market price of XYZ common stock. The principal balance and the proceeds from the obligation is $1,000,000. However, final settlement of the obligation fluctuates with the market price of XYZ common stock. For example, if the price of XYZ common stock rises to $150 per share, the principal repayment amount increases to $1,500,000; if the price declines to $75 per share, the principal repayment amount decreases to $750,000. This index feature is not separable from the debt obligation and Company A could, at its option, settle the debt obligation by delivery of XYZ shares.

Prior to the adoption of Statement 133, Company A had adjusted the balance of the debt obligation based upon changes in the value of XYZ common stock in accordance with EITF Issue No. 86-28, Accounting Implications of Indexed Debt Instruments. (Issue 86-28 requires the debt obligation to be recorded at its settlement amount at each balance sheet date.) Company A, by issuing the indexed debt, had eliminated the risk of loss associated with the XYZ shares. Accordingly, any losses or gains on XYZ shares were being offset by gains or losses on the indexed debt, and both the fair value of the asset and the settlement amount of the debt obligation were being recognized on the balance sheet. Changes in the fair value of the shares of XYZ common stock have been recognized in OCI in accordance with Statement 115. In addition, Company A has recognized changes in the indexed debt obligation's settlement amount in OCI, rather than in the income statement.

It is assumed that the embedded equity-based derivative in the indexed debt instrument is accounted for separately upon adoption of Statement 133.

RESPONSE

Upon transition, the embedded equity-based derivative that (1) was not previously separately accounted for as a derivative under generally accepted accounting principles before the date of initial application of Statement 133 and (2) meets the definition of a derivative under Statement 133 qualifies for the cumulative-effect-type adjustment described in paragraph 52(b) (as amended). Thus, the transition adjustment related to the gain or loss reported in accumulated OCI on the indexed debt obligation (that is, the embedded equity-based derivative instrument) that was considered a hedge of the available-for-sale securities, together with the loss or gain reported in accumulated OCI on the related securities (to the extent of an offsetting transition adjustment for the embedded equity-based derivative instrument), should be reclassified to earnings as a cumulative-effect-type adjustment of both net income and accumulated OCI.

Thus, in the example discussed above, upon initial application of Statement 133, Company A should apply the transition guidance in paragraph 52(b) (as amended) for the pre-existing implicit hedging relationship between the indexed debt obligation and the shares of XYZ common stock that was regarded as a fair value hedge.

The embedded derivative, subsequent to the adoption of Statement 133, may be designated as the hedging instrument in either a fair value or cash flow hedging relationship, provided the appropriate criteria are met.

However, if the reporting entity elects under paragraph 50 not to provide separate accounting for the equity-based derivative embedded in the indexed debt instrument, the entity recognizes no transition adjustment under paragraph 52 with respect to the embedded equity-based derivative, and the guidance in Issue 86-28 would continue to be relevant.

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.