FASB Issues Standards Update

by Leroy Baker, Tax-News.com, New York

16 March 2010

In an attempt to address queries about the intended breadth of the embedded credit derivative scope exception, the US Financial Accounting Standards Board (FASB) has issued an Accounting Standards Update on Derivatives and Hedging (Topic 815).

The transfer of credit risk that is only in the form of subordination of one financial instrument to another (thereby redistributing credit risk) is an embedded derivative feature that should not be subject to potential bifurcation and separate accounting under paragraph 815-10-15-11 and Section 815-15-25.

There is, however, some ambiguity in practice about what paragraph 815-15-15-8 means and whether other embedded credit derivative features, including those in some collateralized debt obligations and synthetic collateralized debt obligations, are subject to the application of paragraph 815-10-15-11 and Section 815-15-25.

Subtopic 815-15 is amended to clarify the scope exception under paragraphs 815-15-15-8 through 15-9 for embedded credit derivative features related to the transfer of credit risk in the form of subordination of one financial instrument to another.

The amendments address how to determine which embedded credit derivative features, including those in collateralized debt obligations and synthetic collateralized debt obligations, are considered to be embedded derivatives that should not be analyzed under Section 815-15-25 for potential bifurcation and separate accounting.

The following circumstances (among others) do not qualify for the scope exception and are subject to the application of paragraph 815-10-15-11 and Section 815-15-25 for potential bifurcation:

• An embedded derivative feature relating to another type of risk (including another type of credit risk) is present in the securitized financial instruments.
• The holder of an interest in a tranche of securitized financial instruments is exposed to the possibility (however remote) of being required to make potential future payments (not merely receive reduced cash inflows) because the possibility of those future payments is not created by subordination. The holder owns an interest in a single-tranche securitization vehicle; therefore, the subordination of one tranche to another is not relevant.
• Other embedded credit derivative features, including those in some collateralized debt obligations and synthetic collateralized debt obligations, are considered embedded derivatives subject to the application of Section 815-15-25 (which involves an analysis of whether the economic characteristics and risks of the embedded credit derivative features are clearly and closely related to the economic characteristics and risks of the host contract), provided that the overall contract is not a derivative in its entirety under Section 815-10-15.
• The economic characteristics and risks of an embedded credit derivative feature that is in a beneficial interest in a securitized financial asset and that exposes the holder of an interest in a tranche of that securitized financial instrument to the possibility (however remote) of being required to make potential future payments (not merely receive reduced cash inflows) should be considered to be not clearly and closely related to the economic characteristics and risks of the host contract and thus to meet the criterion in paragraph 815-15-25-1(a).

In initially adopting the amendments in this Update, an entity may elect the fair value option for any investment in a beneficial interest in a securitized financial asset; that is, the entity may irrevocably elect to measure that investment in its entirety at fair value (with changes in fair value recognized in earnings). The election of the fair value option should be determined on an instrument-by-instrument basis at the beginning of the fiscal quarter of initial adoption. An entity must ensure that an impairment analysis of the investment has been performed before the initial adoption of the amendments in this Update.

These amendments become effective for each reporting entity at the beginning of its first fiscal quarter beginning after June 15, 2010. Early adoption is permitted at the beginning of each entity’s first fiscal quarter beginning after issuance of this Update.

IFRS does not contain an embedded credit derivative scope exception comparable to the scope exception in paragraphs 815-15-15-8 through 15-9. Because the amendments in this Update narrow the breadth of the embedded credit derivative scope exception in those paragraphs, the change moves GAAP closer to converging with IFRS.

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