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FASB Eyeing International Rules to Revise the Definition of a Derivative

Denise Lugo  Editor, Accounting and Compliance Alert

· 5 minute read

Denise Lugo  Editor, Accounting and Compliance Alert

· 5 minute read

The FASB on June 29, 2022, signaled a strong interest in making changes to the definition of a derivative, including taking from the version used under international financial reporting standards (IFRS). No decisions were made.

“There’s been evolving practice over time in terms of thinking about where that definition might apply to contracts that I think people might have thought traditionally weren’t in scope,” FASB Vice Chair James Kroeker said.

“And I would even look at things like variable consideration in revenue, some of those things when the holder or the person making that payment has the transaction I think people say are derivatives,” he said. “Well are those also derivatives for the revenue recipient or is there a scope exception and I think I would look first to the scope exception under IFRS that probably more broadly or more clearly articulates that ‘if it’s basically a performance metric of one of the two parities to the contract that you would think about those types of things deferentially’ and I think there’s good reason for that so I would look at that.”

The topic surfaced in board discussions to establish a new technical and research agenda so that the issues investors said are the most pressing get addressed first. The definition of a derivative falls under Phase 2 of a hedge accounting study, which was on the FASB’s research agenda.

At issue for financial statement preparers and users is that the definition of a derivative under Subtopic 815-10, Derivatives and Hedging—Overall, might be outdated because the nature of transactions have evolved since the June 1998 issuance of FASB Statement (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities.

Further, some have also said that the definition of a derivative often captures transactions that were not originally intended to be accounted for as derivative instruments, according to the discussions.

“I would agree that there are some counterintuitive conclusions sometimes as to what is considered a derivative,” FASB member Marsha Hunt said. “I think that is resulting in costly application of GAAP for both preparers and for practitioners and at the end of the day I’m not convinced that the outcome as to whether some of those are considered a derivative or not is that meaningful to users,” she said.

No Appetite for New Hedging Project

In general, most board members also signaled they would not favor taking on any major standard-setting work to revise hedge accounting at large at this point, wanting to study the results of Accounting Standards Update (ASU) No. 2022-01Derivatives and Hedging (Topic 815): Fair Value Hedging—Portfolio Layer Method, which was recently issued in March.

“I’m not supportive at this point in time on moving towards a project on dynamic risk management; I think that we have made real progress with the portfolio layer method, I think that is just starting to be implemented,” FASB member Fred Cannon said. “We have generally had positive feedback on that from preparers to date, but users have yet to see any of the results from it or be able to evaluate if it has improved financial reporting or not,” he said. “So in my view, I think in terms of hedging overall I’d like to see the portfolio layer method be out there for a while, allow folks to evaluate it, and get some good feedback on that before we make any next steps in terms of hedging.”

The board however will continue to work on codification improvements and monitor hedge and derivatives accounting issues that arise due to the market-wide shift from the use of the London Interbank Offered Rate (LIBOR).

There are challenges in current practice with distinguishing between the hedged risk and the hedged forecasted transaction, according to meeting papers. The change in hedged risk is a significant issue especially because of LIBOR cessation, changing market conventions for interest rates, and an ongoing emergence of replacement rates that an entity may desire to include within an active hedging program in the future.

“For me the LIBOR cessation issues rose to the top of the list,” FASB member Susan Cosper said. “I don’t know how pervasive all of these issues are but certainly would have to do an analysis on that to determine whether and if we should take those on.”


This article originally appeared in the July 6, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.

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