United States

Accounting for contingent put and call options in debt instruments

FINANCIAL REPORTING INSIGHTS  | 

Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 815, Derivatives and Hedging, requires embedded derivatives to be separated from the host contract and accounted for as derivatives if certain criteria are met. One of those criteria is that the economic characteristics and risks of the embedded derivative are not clearly and closely related to the economic characteristics and risks of the host contract. Currently there is diversity in practice as to the requirements for assessing whether contingent call and put options that can accelerate the payment of principal on debt instruments are clearly and closely related to their debt hosts.

To address this diversity in practice, the FASB recently issued Accounting Standards Update (ASU) 2016-06, Derivatives and Hedging (Topic 815): Contingent Put and Call Options in Debt Instruments (a consensus of the Emerging Issues Task Force). ASU 2016-06 clarifies that to assess the embedded call and put options to determine whether the economic characteristics and risks are clearly and closely related to the host contract, an entity should solely consider the four-step decision sequence provided by paragraph 815-15-25-42 and should not consider whether the event that triggers the ability to exercise the call or put is related to interest rates or credit risks. The four-step decision sequence requires an entity to consider whether (1) the payoff is adjusted based on changes in an index, (2) the amount of the payoff is indexed to an underlying other than interest rates or credit risk, (3) the debt involves a substantial premium or discount and (4) the call or put option is contingently exercisable.

For public business entities, the ASU is effective for financial statements issued for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. For entities other than public business entities, the ASU is effective for financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within fiscal years beginning after December 15, 2018. Early adoption is permitted, including adoption in an interim period.