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Negative Comment Letters Lead to Scrapping of Derivatives Disclosure Proposal

The FASB scrapped a project that would have required more information about separately measured embedded derivatives in the notes of financial companies’ financial statements. The proposed disclosure guidance was sharply criticized by banks, auditors, and industry trade groups who said it would not improve the transparency or usefulness of the information in the footnotes.

By a 4-3 vote, the FASB on July 29, 2015, scrapped a project that would have required more information about separately measured embedded derivatives in the notes of financial companies’ financial statements.

A majority of the board agreed to drop the proposal after the feedback from the February Proposal Accounting Standards Update (ASU) No. 2015-220, Derivatives and Hedging (Topic 815): Disclosures about Hybrid Financial Instruments with Bifurcated Embedded Derivatives, was almost universally negative.

“I was convinced by the arguments about the level of aggregation is such that you’re not really providing useful information, and also was convinced by the fact that many times, this is showing an incomplete picture, such that users really get a perhaps distorted view of what that disclosure is really trying to represent,” FASB member Lawrence Smith said.

The proposal called for adding disclosure guidance to FASB ASC 815-10-50-4, Derivatives and Hedging , formerly SFAS No. 133, paragraph 44, about hybrid instruments with embedded derivatives, such as convertible bonds and some types of securitized instruments. The disclosures would have had to explain the effect on earnings of the instrument being hedged and the derivative.

U.S. GAAP allows companies to separate, or “bifurcate,” the reporting of host contracts and the derivatives tied to them. The proposed disclosures were an effort by the board to help investors understand the effect the contracts and derivatives have on a company’s finances.

The proposal had been developed to complement the FASB’s forthcoming accounting standard to change how businesses classify and measure financial instruments. The draft of the amendments on classification and measurement, which were released in February 2013 via Proposed ASU No. 2013-220, Financial Instruments—Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities , eliminated the bifurcation of embedded derivatives in part because investors and analysts long had complained that the process was complex, and the resulting accounting was hard to understand.

As the FASB continued discussing the draft guidance, it decided to retain the separate accounting treatment for host instruments and the derivatives tied to them.

The decision to leave this part of U.S. GAAP unchanged led the FASB to ask its research staff to explore potential new disclosures for hybrid financial instruments with embedded derivatives. The board decided to propose having businesses disclose the carrying amount, measurement attribute, and line item within the balance sheet and income statement in which bifurcated embedded derivatives and related host contracts are presented.

Of the 20 audit firms, companies, and professional groups that responded to the February proposal, however, 19 said it would not improve the transparency or usefulness of information reported in the financial statement footnotes, FASB staff members told the board.

Large banks said they typically elect the option to measure their hybrid financial instruments at fair value, so most of the instruments with embedded derivatives would not be within the scope of the proposed update.

“I would observe this is an understood issue that is circumvented by electing the fair value option, which begs the question, ‘Why use bifurcation at all?'” FASB member Harold Schroeder said. “Maybe a better way to solve the problem is to eliminate the proposed disclosure, but also eliminate bifurcation.”

Schroeder’s idea was a non-starter, considering the larger classification and measurement standard will retain bifurcation.

“And then fair value everything?” FASB Chairman Russell Golden said. “We’ve gone down that path and decided not to do anything.”

Golden was referring to the FASB’s ill-fated 2010 Proposed ASU No. 1810-100, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities—Financial Instruments (Topic 825) and Derivatives and Hedging (Topic 815) , which called for a broad application of fair value accounting to all financial assets and liabilities. The proposal was intended to correct problems from the 2008 financial crisis. But the banking industry roundly criticized it, and the FASB soon retreated from the plan and proceed to work on the guidance that resulted in Proposed ASU No. 2013-220 and the current plan to complete the classification and measurement standard later in 2015 or early in 2016.

Schroeder, who plans to dissent from the final classification and measurement standard, still expressed his disappointment in the project.

“It doesn’t seem like we solved the problem here – the problem is investors don’t understand bifurcation, don’t understand the implications of bifurcation. We haven’t addressed that problem by retaining bifurcation,” he said.

Two other FASB members, Marc Siegel and Thomas Linsmeier, joined Schroeder in voting no against dropping the disclosure proposal.

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