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Derivatives Implementation Group

Statement 133 Implementation Issue No. K5

QUESTIONS

1. When should an entity that has adopted Statement 133 prior to the issuance of newly issued implementation guidance account for the effects of initially complying with that new implementation guidance?

2. How should an entity that has adopted Statement 133 prior to the issuance of newly issued implementation guidance account for the effects of initially complying with that new implementation guidance?

BACKGROUND

FASB Statement No. 154, Accounting Changes and Error Corrections, defines a change in accounting principle as follows:

     A change from one generally accepted accounting principle to another generally accepted accounting principle when there are two or more generally accepted accounting principles that apply or when the accounting principle formerly used is no longer generally accepted. A change in the method of applying an accounting principle also is considered a change in accounting principle.

Statement 154 states in paragraph 4, "A presumption exists that an accounting principle once adopted shall not be changed in accounting for events and transactions of a similar type." In paragraph 5, it states, "A reporting entity shall change an accounting principle only if (a) the change is required by a newly issued accounting pronouncement or (b) the entity can justify the use of an allowable alternative accounting principle on the basis that it is preferable."

Paragraph 6 of Statement 154 states the following:

     It is expected that accounting pronouncements normally will provide specific transition requirements. However, in the unusual instance that there are no transition requirements specific to a particular accounting pronouncement, a change in accounting principle effected to adopt the requirements of that accounting pronouncement shall be reported in accordance with paragraphs 7–10 of this Statement. [Footnote omitted.]

Paragraph 48 of Statement 133 states in part that the provisions of Statement 133 "shall not be applied retroactively to financial statements of prior periods." The transition provisions in paragraphs 49-53 specify the measurement and reporting of the transition adjustments arising from the initial application of Statement 133.

RESPONSE

Question 1

An entity that has adopted Statement 133 prior to the issuance of Board-cleared implementation guidance should account for the effects of initially complying with that new implementation guidance as of the first day of its first fiscal quarter following the date that the Board-cleared guidance is posted on the FASB website unless the Board directs otherwise. That first day of its first fiscal quarter following the posting of the cleared guidance is considered the effective date of the guidance for the reporting entity. However, at the time that the implementation guidance for an issue is cleared, the Board may direct the staff to specify a different effective date if the circumstances for that issue so warrant. Board-cleared guidance will be posted to the website only between the sixth day and the tenth day of each month unless the Board directs otherwise. Each issue cleared in June 2001 or thereafter will indicate its effective date and the date that the issue was posted to the website.

Question 2

I.    Application of Guidance on the Definition of a Derivative,
      Scope Exceptions, and the Recognition and Measurement
      of Derivatives

An entity that has applied the provisions of Statement 133 regarding the definition of a derivative (principally paragraphs 6-9 and related paragraphs), the scope exceptions (paragraphs 10, 11, 14, and 15 and related paragraphs), and the recognition and measurement of derivatives differently than required by subsequently issued cleared implementation guidance should account for the effects of initially complying with that implementation guidance prospectively for all existing contracts and future transactions, as of the effective date for that guidance. The effects of initially applying that implementation guidance should be reported as a change in accounting principle consistent with the transition provisions of Statement 133 (that is, no restatement of the financial statements for either interim or annual periods prior to the effective date of that guidance). However, in order to be consistent with the transition provisions of Statement 133 and because no retroactive designation of hedging relationships and no retroactive application of the implementation guidance are permitted, no pro forma disclosures of the effects of retroactive application are required or permitted.

1. This guidance encompasses situations in which (1) an entity did not account for a contract as a freestanding derivative instrument under Statement 133 but is required to do so under the newly issued implementation guidance and (2) an entity accounted for a contract as a derivative instrument under Statement 133 but will not account for that contract as a derivative instrument under the newly issued implementation guidance. Accounting for a contract as a freestanding derivative instrument to comply with newly issued implementation guidance could result in reporting a cumulative-effect-type adjustment in that period. The treatment described above is consistent with Statement 133's transition provisions, which require application to derivative instruments existing at the date of adoption, not just to contracts entered into after the Statement's adoption. If an entity had been accounting for a contract as a derivative under Statement 133 but will not do so under the newly issued implementation guidance, the contract's fair value at the effective date shall become its net carrying amount at that date. The entity should apply other generally accepted accounting principles that are applicable to that contract prospectively from the date that the contract ceased to be accounted for under Statement 133. (Prospective application only to future transactions would not be appropriate.) For entities that transferred securities subject to FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, between categories of investments pursuant to paragraphs 54 and 55 of Statement 133 in conjunction with the initial application of Statement 133, the posting of newly issued implementation guidance does not justify reversing those transfers.

2. Relevant implementation guidance related to the application of the definition of a derivative, the scope exceptions, and the recognition and measurement of derivatives is found in Sections A, C, and D, respectively, of the implementation guidance. In addition, this method of transition would also be applicable to guidance of the type in Statement 133 Implementation Issue No. K1, "Determining Whether Separate Transactions Should be Viewed as a Unit," which addresses when separate transactions must be viewed as a unit in order to determine whether they meet the definition of a derivative.

Notwithstanding the above, at the time that the implementation guidance for an issue is cleared, the Board may direct the staff to specify different guidance if the circumstances for that issue so warrant.

II.    Separate Accounting for Embedded Derivatives

This aspect of Statement 133, which is found in Section B of the implementation guidance, has two dimensions:

1. Determining whether or not an embedded derivative must be accounted for separately. An entity that has or has not separately accounted for an embedded derivative in a manner that is different from the requirements of the newly issued cleared implementation guidance should account for the effects of initially complying with that new implementation guidance prospectively, for all existing contracts and future transactions, as of the effective date, except for the existing contracts that qualify for the grandfathering provisions of paragraph 50 that exempt certain hybrid instruments from the embedded derivative provisions of Statement 133 on an all-or-none basis. (For example, if a company elected on adoption of Statement 133 pursuant to paragraph 50 to bifurcate only those hybrid instruments acquired or substantively modified after December 31, 1998, the company could not apply newly issued implementation guidance to hybrid instruments acquired before January 1, 1999.) The effects of initially applying the implementation guidance should be reported as a change in accounting principle consistent with the transition provisions of Statement 133 (that is, no restatement of the financial statements for periods prior to the effective date of that guidance). However, in order to be consistent with the transition provisions of Statement 133 and because no retroactive designation of hedging relationships and no retroactive application are permitted, no pro forma disclosures of the effects of retroactive application are required or permitted. For entities that transferred securities subject to Statement 115 between categories of investments pursuant to paragraphs 54 and 55 of Statement 133 in conjunction with the initial application of Statement 133, the posting of newly issued implementation guidance does not justify reversing those transfers.
   

   This guidance encompasses situations in which (1) an entity did not separately account for an embedded derivative but is required to do so under the newly issued cleared implementation guidance, (2) an entity accounted separately for an embedded derivative but may not account for that embedded derivative separately under the newly issued implementation guidance, and (3) an entity accounted for the entire hybrid instrument at fair value (pursuant to paragraph 16) based on a determination that it could not reliably identify and measure the separate embedded derivative, but the embedded derivative may not be accounted for separately under the newly issued implementation guidance (and, therefore, paragraph 16 cannot be cited as justification for accounting for the hybrid instrument at fair value). Consistent with the application of guidance on the definition of a derivative and scope exceptions, prospective application only to hybrid contracts entered into on or after the effective date of the guidance would not be appropriate. If under the newly issued implementation guidance an entity may not account separately for an embedded derivative that has been separately accounted for under the entity's application of Statement 133, the carrying amount of the related hybrid instrument at the guidance's effective date should be the sum of the carrying amount of the host contract and the fair value of the embedded derivative.

2. Different mechanics for separating an embedded derivative from a host instrument.
   Newly issued cleared implementation guidance that relates to the mechanics of separating an embedded derivative from a host instrument (rather than to the fundamental determination of whether an embedded derivative must be accounted for separately) should be applied prospectively; that is, only to future hybrid contracts entered into on or after the effective date of the guidance.
   

   Examples of guidance that relates to the mechanics of separating an embedded derivative from a host instrument can be found in Statement 133 Implementation Issues No. B19, "Identifying the Characteristics of a Debt Host Contract," No. B20, "Must the Terms of a Separated Non-Option Embedded Derivative Produce a Zero Fair Value at Inception?," No. B22, "Whether the Terms of a Separated Option-Based Embedded Derivative Must Produce a Zero Fair Value (Other than Time Value)," and No. B23, "Terms of a Separated Non-Option Embedded Derivative When the Holder Has Acquired the Hybrid Instrument Subsequent to Its Inception."

Notwithstanding the above, at the time that the implementation guidance for an issue is cleared, the Board may direct the staff to specify different guidance on the accounting for embedded derivatives if the circumstances for that issue so warrant.

III.    Hedging Relationships

This aspect of Statement 133 has two dimensions:

1. Not qualifying for hedge accounting.
   An entity that had designated a qualifying hedging relationship that no longer qualifies for hedge accounting based on newly issued cleared implementation guidance must dedesignate that hedging relationship prospectively (that is, the hedging relationship must be dedesignated at the effective date). If the hedging relationship had been a fair value hedge, the recognition in earnings of the adjustment of the carrying amount of the hedged asset or liability under paragraphs 22 and 23 for the period prior to the effective date should not be reversed. Rather, the adjustment of the carrying amount of the hedged item under paragraph 22 should be accounted for under paragraph 24. If the hedging relationship had been a cash flow hedge or a net investment hedge, the derivative's gain or loss for the period prior to the effective date shall remain in accumulated other comprehensive income (OCI) and be reclassified into earnings consistent with the provisions of paragraphs 33 and 42.
   
2. Different mechanics of hedge accounting.
   An entity that had applied the mechanics of hedge accounting (for example, the measurement of hedge effectiveness or the application of the shortcut method) differently than is required by newly issued cleared implementation guidance must apply that guidance prospectively to existing and future hedging relationships. (Thus, for example, an existing hedging relationship that is incorrectly being accounted for under the shortcut method would have to prospectively discontinue use of the shortcut method at the effective date and apply instead regular fair value or cash flow hedge accounting for that relationship, without any change to previously recognized amounts in OCI or to previous adjustments of the carrying amount of the hedged item.) Essentially, this is analogous to requiring dedesignation of hedging relationships with the previously used hedge accounting mechanics and redesignation of hedging relationships with the hedge accounting mechanics that are consistent with the newly issued implementation guidance. (For dedesignated cash flow hedges, the derivative's gain or loss for the period prior to the effective date shall remain in accumulated OCI and be reclassified into earnings consistent with the provisions of paragraphs 33.) Thus, it is consistent with requiring (under (A) above) the dedesignation of previous hedging relationships that under the newly issued guidance no longer qualify as a fair value hedge, cash flow hedge, or net investment hedge.
   

Relevant implementation guidance related to the application of hedge accounting is included in Section E (Hedging-General), Section F (Fair Value Hedges), Section G (Cash Flow Hedges), and Section H (Foreign Currency Hedges) of the implementation guidance.

Notwithstanding the above, at the time that the implementation guidance for an issue is cleared, the Board may direct the staff to specify different guidance related to the application of hedge accounting if the circumstances for that issue so warrant.

IV.    Application of Statement 133's Transition Provisions

An entity is permitted to apply newly issued implementation guidance related to the transition provisions retroactively to fiscal periods that ended prior to the effective date of that guidance provided that the entity has not published any interim or annual financial statements reflecting the related transition adjustment determined under the entity's application of Statement 133. (The phrase published any interim or annual financial statements is used in a manner analogous to the guidance in FASB Technical Bulletin No. 79-18, Transition Requirement of Certain FASB Amendments and Interpretations of FASB Statement No. 13.) However, an entity is not required to retroactively apply any transition implementation guidance that is posted after the entity has initially applied Statement 133. Relevant implementation guidance related to the transition provisions is included in Section J (Transition Provisions).

V.    Other Aspects of Statement 133

An entity that adopted Statement 133 prior to the issuance of cleared implementation guidance related to other areas (including Section I (Disclosures) and Section K (Miscellaneous), with the exception of the type of guidance in Implementation Issue K1) should apply that guidance prospectively; that is, only to future events and transactions and future designated hedging relationships. Implementation guidance related to those areas may not be applied to hedging relationships designated and contracts entered into prior to the issuance of that guidance.

Notwithstanding the above, at the time that the implementation guidance for an issue is cleared, the Board may direct the staff to specify retroactive application of that guidance if the circumstances for that issue so warrant.

Implications of the Foregoing Guidance to Question 1

• If an instrument was previously accounted for as a derivative but may not be under the newly issued implementation guidance, and that instrument had been designated as a hedging instrument, the entity must dedesignate the hedging relationship at the effective date. (Such dedesignation has only a prospective impact, although if a cash flow hedge is dedesignated, paragraph 33 may require certain gains and losses in accumulated OCI to be reclassified into earnings on the effective date.) Similarly, if an embedded derivative was previously accounted for separately but may not be under the newly issued implementation guidance, and that instrument had been designated as a hedging instrument, the entity must dedesignate the hedging relationship at the effective date.

• If an instrument was not previously accounted for as a derivative but must be under the newly issued implementation guidance, an entity is not permitted to retroactively designate that instrument in a hedging relationship. Similarly, if an embedded derivative was not previously accounted for separately but must be under the newly issued cleared implementation guidance, an entity is not permitted to retroactively designate that embedded derivative as a hedging instrument. The separated derivative may be designated as a hedging instrument on a prospective basis.

• If newly issued cleared implementation guidance permits hedge accounting for a certain scenario (for which no hedging relationship had been designated), an entity is not permitted to retroactively apply hedge accounting (that is, an entity may not retroactively designate a hedging relationship). Hedge accounting may be applied for that scenario only on a prospective basis from the date that the relationship is designated and documented.

• If an entity had determined that an embedded derivative must be accounted for separately but had also determined that it could not reliably separate and measure the embedded derivative at fair value and therefore accounted for the entire hybrid instrument at fair value under paragraph 16, and if the newly issued cleared implementation guidance indicates that the embedded derivative may not be accounted for separately, the entity must discontinue mark-to-market accounting for the hybrid instrument as of the effective date and account for the hybrid instrument under relevant GAAP prospectively. In that case, the carrying amount of the hybrid instrument is its fair value at the effective date of the guidance.

This Issue does not apply to situations in which an entity's previous accounting treatment was not reasonable or was inconsistent with Statement 133 and previously posted cleared implementation issues.

EFFECTIVE DATE

The implementation guidance in this Issue is effective for all financial statements issued for fiscal quarters beginning after June 30, 2001.

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.