Heads Up — FASB issues ASUs in response to EITF consensuses
This issue discusses three ASUs which were recently issued by the FASB in response to consensuses reached by the Emerging Issues Task Force (EITF). The Heads Up summarizes each ASU’s background, key provisions, effective date, and transition requirements.
In response to consensuses reached by the Emerging Issues Task Force (EITF), the FASB has issued the following three Accounting Standards Updates (ASUs):
- Recognition of Breakage for Certain Prepaid Stored-Value Products (ASU 2016-04).
- Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships (ASU 2016-05).
- Contingent Put and Call Options in Debt Instruments (ASU 2016-06).
This Heads Up discusses each ASU’s background, key provisions, effective date, and transition requirements.
Prepaid Stored-Value Products (ASU 2016-04)
Entities may sell prepaid stored-value products in physical and digital forms that can be redeemed by the holder to purchase goods or services. When an entity sells a prepaid stored-value product, it recognizes a liability to the product holder. As the holder redeems the prepaid stored-value product, the entity reduces its liability to the holder and settles its liability to the merchant that provided the goods or services. For various reasons, product holders may not use any or a portion of the product’s prepaid value (commonly referred to as “breakage“). There is diversity in practice related to when an entity can derecognize the liability to the product holder as a result of breakage.
ASU 2016-04 amends the guidance on extinguishing financial liabilities for certain prepaid stored value products (see the discussion of the ASU’s scope below). If an entity selling prepaid stored-value products expects to be entitled to a breakage amount (i.e., an amount that will not be redeemed), the entity will recognize the effects of the expected breakage “in proportion to the pattern of rights expected to be exercised“ by the product holder to the extent that it is probable that a significant reversal of the breakage amount will not subsequently occur. That is, an entity would not recognize breakage immediately but rather proportionally as the prepaid stored-value product is being redeemed. Otherwise, the expected breakage would be recognized when the likelihood becomes remote that the holder will exercise its remaining rights.
Entities are required to reassess their estimate of breakage each reporting period. Any change in this estimate would be accounted for as a change in an accounting estimate. An entity that recognizes breakage is required to disclose the “methodology used to recognize breakage and significant judgments made in applying the breakage methodology.“ Further, prepaid stored-value products within the scope of the ASU are excluded from the disclosure requirements in ASC 825 for financial liabilities.
Editor’s Note: The derecognition amendments in ASU 2016-04 are consistent with the views expressed by the SEC staff and the method of accounting for breakage described in ASC 606, including the “constraint“ under which an entity recognizes the effects of the expected breakage to the extent that it is probable that a significant reversal of breakage will not subsequently occur. Entities may consider ASC 606-10-32-12, which lists factors that could increase the likelihood or magnitude of a subsequent reversal.
Derivative Contract Novations (ASU 2016-05)
A derivative novation occurs when one party to the derivative contract assigns its rights and obligations to a new party (i.e., legally replaces itself with another party). Approval for the novation is typically required of the existing derivative counterparty. After the novation, the entity that was replaced by the new party no longer has any rights or obligations under the contract.
Derivative novations can occur for various reasons, including the following:
- As a result of a financial institution merger, to designate the surviving entity as the new counterparty.
- As a vehicle for exiting a line of business or moving risk exposures between different legal entities of the same parent company.
- To satisfy laws or regulatory requirements (e.g., as a means of complying with requirements to use central derivative clearing counterparties).
Under ASC 815, an entity must discontinue a hedging relationship if (1) the hedging derivative instrument expires or is sold, terminated, or exercised or (2) it wishes to change a critical term of the hedging relationship. ASC 815 does not, however, explicitly address how a novation of a hedging derivative affects a hedging relationship, and this ambiguity has resulted in inconsistent application in practice. ASU 2016-05 clarifies whether a change in the hedging derivative’s counterparty should, in and of itself, trigger discontinuation of a hedging relationship (i.e., require the entity to de-designate the hedge).
Editor’s Note: In a May 2012 letter to the International Swaps and Derivatives Association and in a speech at the 2014 AICPA Conference on Current SEC and PCAOB Developments, the SEC staff gave examples of situations in which it would not object to the continuation of an existing hedging relationship after a novation of the hedging derivative. The examples were intended to address concerns about the ramifications of then-recent legislation and rulemaking requiring the central clearing of certain derivative transactions and to limit diversity in practice. ASU 2016-05 shifts this paradigm; thus, an entity will now assume that a novation, by itself, will not force it to unwind its hedge instead of assuming that the hedge must be unwound unless the novation qualifies for a specified exception.
ASU 2016-05 clarifies that “a change in the counterparty to a derivative instrument that has been designated as the hedging instrument in an existing hedging relationship would not, in and of itself, be considered a termination of the derivative instrument“ (emphasis added) or “a change in a critical term of the hedging relationship.“ As long as all other hedge accounting criteria in ASC 815 are met, a hedging relationship in which the hedging derivative instrument is novated would not be discontinued or require redesignation. This clarification applies to both cash flow and fair value hedging relationships.
Editor’s Note: The Basis for Conclusions of ASU 2016-05 states that “a reporting entity always is required to assess the creditworthiness of the derivative instrument counterparty in a hedging relationship (both in the normal course of the hedging relationship and upon a novation).“Although an entity would not be required to discontinue the hedging relationship solely as a result of a change in counterparty, the entity would need to consider the counterparty’s creditworthiness. If the new counterparty’s creditworthiness differs significantly from that of the original counterparty, the hedging relationship may no longer be a highly effective hedge, which would trigger discontinuation of the hedged relationship.
Contingent Put and Call Options in Debt Instruments (ASU 2016-06)
To determine how to account for debt instruments with embedded features, including contingent put and call options, an entity is required to assess whether the embedded derivatives must be bifurcated from the host contract and accounted for separately. Part of this assessment consists of evaluating whether the embedded derivative features are clearly and closely related to the debt host. Under existing guidance, for contingently exercisable options to be considered clearly and closely related to a debt host, they must be indexed only to interest rates or credit risk.
ASU 2016-06 addresses inconsistent interpretations of whether an event that triggers an entity’s ability to exercise the embedded contingent option must be indexed to interest rates or credit risk for that option to qualify as clearly and closely related. Diversity in practice has developed because the existing four-step decision sequence in ASC 815-15-25-42 focuses only on whether the payoff was indexed to something other than an interest rate or credit risk. As a result, entities have been uncertain whether they should (1) determine whether the embedded features are clearly and closely related to the debt host solely on the basis of the four-step decision sequence or (2) first apply the four-step decision sequence and then also evaluate whether the event triggering the exerciseability of the contingent put or call option is indexed only to an interest rate or credit risk (and not some extraneous event or factor).
The ASU clarifies that in assessing whether an embedded contingent put or call option is clearly and closely related to the debt host, an entity is required to perform only the four-step decision sequence in ASC 815-15-25-42 as amended by the ASU (see the appendix). The entity does not have to separately assess whether the event that triggers its ability to exercise the contingent option is itself indexed only to interest rates or credit risk.
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Heads Up newsletters, published as warranted, analyze important accounting developments, such as new FASB and IASB pronouncements or exposure drafts. Concise examples and answers to frequently asked questions assist readers in understanding and implementing the critical guidance.