FASB proposes guidance to refine the scope of derivative accounting

ARTICLE | August 09, 2024

The Financial Accounting Standards Board (FASB) recently issued a proposed Accounting Standards Update (ASU), Derivatives and Hedging (Topic 815) and Revenue from Contracts with Customers (Topic 606): Derivatives Scope Refinements and Scope Clarification for a Shared-based Payment from a Customer in a Revenue Contract, to address stakeholder concerns regarding:

• Application of derivative accounting to contracts with features based on the operations or activities of one of the parties to the contract.
• Diversity in accounting for share-based payments from customers as consideration for the transfer of goods or services.

Stakeholders are encouraged to review and provide input on the proposed ASU by October 21, 2024.

Derivatives scope refinements for certain contracts with features based on the operations or activities of the parties to the contract

In response to the 2021 Invitation to Comment, Agenda Consultation, stakeholders noted challenges in applying the definition of a derivative and its related scope exceptions in Topic 815. These challenges relate to certain emerging transactions like bonds whose interest payments vary based on environmental, social and governance (ESG)-linked metrics, and certain long-standing transactions like research and development funding arrangements and litigation funding arrangements.

A frequently noted challenge was the broad and evolving interpretation of the derivative definition and the complexity of applying scope exceptions to certain contracts with variables (referred to as “underlyings”) based on activities or operations specific to one of the parties to the contract. Some stakeholders indicated that because those contracts relate to the performance of one of the parties to the contract, accounting for them as derivatives measured at fair value does not provide decision-useful information. In addition, those stakeholders noted that generally accepted accounting principles already provide accounting guidance for those contracts and they believe that guidance would result in more useful information for investors compared to derivative accounting.

To address stakeholder concerns, the proposed ASU would amend the scope exceptions in Topic 815 to exclude from derivative accounting contracts with underlyings that are based on financial statement metrics of one of the parties to the contract (e.g., earnings before interest, taxes, depreciation and amortization, net income, expenses, or total equity), as well as the occurrence or nonoccurrence of an event related to the activities or operations specific to one of the parties to the contract. The FASB decided that underlyings based on (a) a market rate, market price or market index, including those in paragraph 815-10-15-88 (a) through (f), or (b) the price or performance of a financial asset or financial liability of one of the parties to the contract would not be captured by the proposed scope exception. The FASB added this restriction so that instruments that are commonly understood to be derivatives (e.g., interest rate swaps, credit default swaps and commodity forward contracts) would not be inadvertently captured by the proposed scope exception.

Currently, when a contract (or an embedded feature in a hybrid instrument) has more than one underlying and some, but not all, of them qualify for the scope exception in Topic 815, an entity must perform a predominant characteristics assessment. That assessment is needed to determine whether the freestanding contract (in its entirety) or an embedded feature (in a hybrid instrument) qualifies for the derivative scope exception.

The FASB noted that the current requirement to perform a correlation analysis to determine the predominant underlying is difficult to apply and because the proposed expansion of the scope exception is expected to result in more frequent application of that guidance, the Board decided to make the assessment more operable. Specifically, the proposed ASU would replace the existing correlation analysis with a fair value assessment. Under the proposed fair value assessment, the underlying with the largest expected effect on the overall fair value of the contract would be considered the predominant underlying.

Scope clarification for a share-based payment from a customer in a revenue contract

The proposed ASU would clarify the applicability of Topic 606 and its interaction with Topic 815 or Topic 321, Investments – Equity Securities, when accounting for share-based payments, such as warrants or shares, received from customers as consideration in exchange for the transfer of goods or services. More specifically, the FASB decided to make it explicit in Topic 606 that an entity should apply that standard, including its noncash consideration guidance, to a contract with a customer who makes a share-based payment (e.g., shares or share options) as consideration for the transfer of goods or services. The FASB also decided to make consequential amendments to Topic 815 and Topic 321 to clarify that those standards should not be applied unless and until the share-based payment is recognized as an asset (and measured at the estimated fair value at contract inception) under Topic 606.

Proposed effective date and transition requirements

The effective date for the proposed ASU will be determined after the FASB considers feedback from stakeholders.

The proposed amendments related to the derivatives scope refinement would be applied prospectively to all new contracts that are entered into on or after the effective date of adoption. Entities would have the option to apply the proposed amendments to contracts that exist as of the beginning of the fiscal year of adoption through a cumulative-effect adjustment made to the opening balance of retained earnings as of the beginning of the fiscal year of adoption. The Board also decided to provide a one-time instrument-by-instrument option to irrevocably elect the option to measure certain contracts in their entirety at fair value with changes in fair value recognized in earnings. Early adoption would be permitted as of the beginning of the fiscal year.

Entities would be required to apply the proposed amendments related to the scope clarification for share-based payments to revenue contracts that exist as of the beginning of the fiscal year of adoption. The cumulative effect of the change would be recognized as an adjustment to the opening balance of retained earnings as of the beginning of the fiscal year of adoption. Early adoption would be permitted as of the beginning of the fiscal year.

Source: RSM US LLP.
Reprinted with permission from RSM US LLP.
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