The FASB’s Emerging Issues Task Force (EITF) approved two small clarifications to hedge accounting.The first deals changes of trading partners in certain types of derivatives trades and how they affect the ability to continue the use of hedge accounting.The second attempts to clear up conflicting views about separating the measurement of some types of put and call options from their host contracts.

The FASB’s Emerging Issues Task Force (EITF) on June 18, 2015, approved two narrow clarifications to hedge accounting and voted to send them to the FASB for public comment.

The FASB plans to vote on the proposals at its July 9 meeting.The accounting board must approve all EITF decisions before they can be published.

The first issue, EITF Issue No. 15-D, “Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships,” deals with whether changing a trading partner in certain types of derivatives deals means the first party must stop using hedge accounting.

The second, EITF Issue No. 15-E, “Contingent Put and Call Options in Debt Instruments,” attempts to address conflicting views about the economic characteristics and risks of embedded put or call options.Users of the options have to evaluate the relationship between the options’ characteristics and the debt instrument they are based on.The relationship determines whether the host contracts and the derivatives have to be accounted for separately, or “bifurcated.”

For the first issue, the task force agreed that a change in trading partner — called “novation” — would not automatically result in the loss of the ability to apply hedge accounting to a derivatives contract.

Novation is a legal concept derivatives traders use when they replace one party to the contract with another, typically a central clearinghouse.Instead of two banks trading derivatives directly with one another, the contracts are written with a clearinghouse acting as a middleman.The partners to the original trade are still buying and selling the same instruments, but they are dealing with one another indirectly because the clearinghouse is now in the middle of the trade.

Regulators prefer that banks use clearinghouses to settle their derivatives trades because the clearinghouses are expected to have stronger capital cushions and are in a better position to withstand the default of a trading partner.

Novations also happen if one of the partners to a swaps trade is bought or it sells its swaps portfolio to another bank, the FASB’s research staff said.

Under Topic 815,Derivatives and Hedging, hedge accounting can not be applied to a derivative if the instrument is terminated or there has been a change in the “critical terms” of deal.Accountants have questioned whether a change in one of the parties to a trade constitutes a change in the critical terms.

A majority of the task force agreed that a change in parties by itself was not enough to trigger a loss of the ability to use hedge accounting.

“On the surface you just look at it, it’s, ‘Who’s the contract between?If you change who it’s between, how can that not be an important term?’I get that,” EITF member John Althoff, a PricewaterhouseCoopers LLP partner, said.

EITF members placed more weight on the creditworthiness of the new trading partner or middleman.If the new party to the trade has a lower credit rating, that would trigger a loss in the ability to use hedge accounting, Althoff said.

“So the critical term is not who the person is, it’s knowing that there’s not going to be a default.Are we reassured the counterparty will perform?” he said.

Put/Call Options

On EITF Issue No. 15-E, the task force agreed 7-5 that a business assessing whether a certain type of put or call option embedded in a debt instrument must be separated from its host and recorded at fair value through earnings should follow a four-step test in Topic 815.

The other view was that the test was just one part of the assessment.

Under Topic 815, debt instruments that contain embedded features must be evaluated to determine whether the features must be accounted for separately from the host contract.

Embedded derivatives must be separated from the host and accounted for as separately if the embedded derivative’s economic characteristics are not clearly and closely related to the host’s characteristics; the contract is not measured at fair value with changes in value reported in earnings; and a separate instrument with the same term as the embedded derivative would meet the definition of a derivative.

While there is specific guidance for puts and calls in Topic 815, including a four-step decision sequence to determine whether a put or call option that accelerates the repayment of principal in a debt contract is “clearly and closely related” to the debt instrument, questions have arisen about the application of the accounting standard.

Some accountants question the relationship between a contingent call or put option and its host contract if the ability to exercise the option is only indexed to interest rates or credit risk and not “some extraneous event or factor.”

Under the task force’s decision, businesses would not have to also consider the contingent event that triggers the option and the four-step test.

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