Derivatives Implementation Group

Statement 133 Implementation Issue No. B18

QUESTION

If a contract, in its entirety, meets the definition of a derivative as set forth in paragraphs 6–9 of Statement 133 but qualifies for a scope exception under paragraph 10(b), must that contract also be assessed under paragraph 12 to determine whether it is a hybrid instrument that contains an embedded derivative that must be accounted for separately?

BACKGROUND

Paragraph 10 of Statement 133 indicates that derivative instruments that meet the criteria in paragraph 10(b) for the normal purchases and normal sales exception are not subject to the requirements of that Statement.

Paragraph 12 of Statement 133 states,

   Contracts that do not in their entirety meet the definition of a derivative instrument (refer to paragraphs 6-9), such as bonds, insurance policies, and leases, may contain "embedded" derivative instruments-implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument....An embedded derivative instrument shall be separated from the host contract and accounted for as a derivative instrument pursuant to this Statement if and only if all of the following criteria are met:

1. The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract....

    

2. The contract ("the hybrid instrument") that embodies both the embedded derivative instrument and the host contract is not remeasured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur.

    

3. A separate instrument with the same terms as the embedded derivative instrument would, pursuant to paragraphs 6-11, be a derivative instrument subject to the requirements of this Statement....

In June 2000, the FASB issued FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of Statement 133. Statement 138 revised Example 31 in paragraph 197 of Statement 133 to indicate that a compound derivative (in the example, representing a foreign currency derivative and a forward commodity contract) cannot be separated into its components and accounted for separately under Statement 133. Paragraph 10(b) (as amended by Statement 138 and Statement 149) states that “contracts that have a price based on an underlying that is not clearly and closely related to the asset being sold or purchased (such as a price in a contract for the sale of a grain commodity based in part on changes in the S&P index) or that are denominated in a foreign currency that meets none of the criteria in paragraphs 15(a)–15(d) shall not be considered normal purchases and normal sales.” Thus, the example contract in paragraph 197 must be accounted for as a derivative.

RESPONSE

No. A contract that meets the definition of a derivative in its entirety but qualifies for a scope exception under paragraph 10(b) of Statement 133 should not also be assessed under paragraph 12. Paragraph 12 applies only to contracts that do not meet the definition of a derivative in their entirety. That conclusion is not changed by the fact that a contract that meets the definition of a derivative in its entirety is not subject to the requirements of Statement 133 pursuant to a scope exception provided by paragraph 10(b).

Statement 133 does not intend for a contract to both meet the definition of a derivative in its entirety and be considered a hybrid instrument that contains an embedded derivative that requires separate accounting. Paragraph 12 explicitly states, "Contracts that do not in their entirety meet the definition of a derivative instrument (refer to paragraphs 6-9), such as bonds, insurance policies, and leases, may contain "embedded" derivative instruments...." (Emphasis added.)

The exception outlined in paragraph 10(b) is written narrowly to permit only a subset of contracts with certain specific characteristics to qualify. If a contract has characteristics that extend beyond those described in paragraphs 10(b) and 58(b), the application of the scope exception is not permitted and the contract, in its entirety, must be accounted for as a derivative. As noted above, contracts that have a price based on an underlying that is not clearly and closely related to the asset being sold or purchased (such as a price in a contract for the sale of a grain commodity based in part on changes in the S&P index) or that are denominated in a foreign currency that does not meet the criteria in paragraphs 15(a)–15(d) shall not be considered normal purchases and normal sales. An entity is prohibited from separating a compound derivative into a portion that qualifies for the scope exception under paragraph 10(b) and a portion that must be accounted for as a derivative under Statement 133. Example 31 in paragraph 197 of Statement 133 (as amended by Statement 138) provides explicit guidance that prohibits such bifurcation.

If a contract meets the criteria to qualify for that scope exception, that contract is not subject to the accounting requirements of Statement 133 for derivatives, but rather shall be accounted for based on generally accepted accounting principles applicable to instruments of that type.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.