The nation’s accounting rulemaker plans to propose rules this summer that would keep the boundaries of complex derivatives accounting rules in check.
The Financial Accounting Standards Board (FASB) on April 10, 2024, voted to issue a narrow proposal to clarify which types of arrangements would meet the definition of a derivative and which would be exempt under Topic 815, Derivatives and Hedging.
Rulemaking efforts started last year after the board heard that the definition of a derivative is being too broadly applied, often going beyond what was intended when it was put in place about 20 years ago.
The proposal will be issued with a 90-day comment period, the board agreed.
“I think this is an extremely important standard; I think reining in the ever-expanding definition of a derivative is a challenge and I think this is good first step,” Chair Richard Jones said. “I do hope that to the extent that there are other items out there that we have missed, that some might through say a derivative lens all of a sudden identify as a derivative that most people have accounted for differently for years under other literature, if there’s any others I hope people raise those to us,” he said.
Full Board Affirmed Issuing Proposal
All board members signaled hope that the proposal will be well-received. Vice Chair James Kroeker, whose second term ends in June, said he “long sought to address this issue with the increasing scope interpretations of derivative accounting evolving over time.”
Similarly, Susan Cosper noted that where the board “landed on this issue was good,” and Marsha Hunt observed that the proposed guidance “would be well received.” In addition to Jones, Kroeker, Cosper, and Hunt represent the financial statement preparer and auditor voices on the board.
The “financial statement user” voices on the board also favored the proposal, although some remarks were cautious.
Specifically, Christine Botosan said “pending what we learned through the exposure draft process, the benefits would exceed the costs.” Frederick Cannon said he believes “that this is a step forward in terms of the definition of a derivative” but certain questions should be included, and Joyce Joseph said “the cost-benefit analysis was particularly beneficial for organizations where they should no longer be deterred from entering into certain arrangements—that’s very important that the accounting doesn’t affect business decisions that entities would make in this regard.”
More Innovative Arrangements Emerging
The potential changes have become more pressing these days as innovative arrangements have developed, including around environmental, social, and governance (ESG)-linked financial instruments, research and development (R&D) funding arrangements, and litigation funding arrangements.
At a meeting last year, staff members heard from the board’s stakeholders that the current derivatives guidance is complex to apply to those types of new arrangements, as well as unintuitive.
Other challenges include, estimating the fair value of these arrangements as this requires significant judgment resulting in subjective fair value measurements that may not be the best reflection of the economics of those arrangements. Accounting for those arrangements in their entirety or bifurcating an embedded derivative from these arrangements, may not necessarily facilitate the analyses performed by investors, those discussions revealed.
Expanding Derivatives Scope Exception
Today, companies have to evaluate whether an arrangement as a whole meets the definition of a derivative or has an embedded feature that meets the definition of a derivative. If the arrangement meets the definition of a derivative, companies must evaluate whether the arrangement (or embedded feature) qualifies for any of the derivatives scope exceptions. Those that meet the definition can use the scope exception in the rules. Arrangements that meet the criteria of the definition of a derivative must be marked to market through the income statement.
The FASB agreed to propose that the current derivatives scope exception should be expanded to include “contracts with underlyings based on the operations or activities” that are specific to one of the parties to the contract. This means that more arrangements would be able to avoid using derivatives accounting rules.
The proposal would also address the interaction of Topic 815, Topic 321, Investments—Equity Securities, and Topic 606, Revenue from Contracts with Customers, related to certain revenue arrangements involving noncash consideration.
The board also voted:
- to refine the predominant characteristics assessment in paragraph 815-10-15-60 by replacing the correlation assessment with a fair value assessment. That assessment should be performed at inception.
- to require prospective application with an option to elect modified retrospective.
- to allow a one-time option for entities to elect the fair value option for eligible financial instruments that are no longer accounted for as a derivative as a result of applying the new guidance.
- to allow early application, including early application in an interim period as of the beginning of the fiscal year that includes that interim period.
This article originally appeared in the April 12, 2024, edition of Accounting & Compliance Alert, available on Checkpoint.
Get all the latest tax, accounting, audit, and corporate finance news with Checkpoint Edge. Sign up for a free 7-day trial today.
