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Background
Stakeholders have increasingly raised questions about the relevance of the derivative scoping guidance, asserting that current guidance has been challenging to apply to emerging and evolving categories of contracts. Much recent feedback has focused on two issues:
- Difficulties in interpreting the appropriate accounting for certain contracts with features based on the performance or activities of one of the parties to the contract – such as litigation and research and development (R&D) funding arrangements or environmental, social, and governance (ESG)-linked bonds – and questions on whether fair value measurement provides decision-useful information for those that are determined to be derivatives.
- Differing perspectives on the appropriate application of accounting guidance when an entity receives a share-based payment as consideration for providing goods or services to a customer under Topic 606.
In response to this feedback, the FASB issued a proposed Accounting Standards Update (ASU) that aims to refine the derivative scoping guidance and clarify the accounting for revenue contracts involving share-based consideration.
Breaking it down
Contracts based on operations or activities of a contract party
The proposal would add to the list of derivative scope exceptions an exception for non-exchange-traded contracts with underlyings based on the operations or activities specific to one of the contract parties. Under Topic 815, an underlying is a variable that affects the settlement amount, including the exercisability, of a contract (for example, market rates, security and commodity prices, and the occurrence or nonoccurrence of an event). Notably, the proposed scope exception would include the following underlyings that are specific to one of the contract parties:
- Financial statement metrics – for example, EBITDA, net income, expenses, and total equity
- Achievement of ESG targets – for example, additional interest required under a debt instrument upon the failure to meet certain ESG measures
- Regulatory approval or attainment of other product development milestone – for example, under certain R&D funding arrangements
- Litigation outcomes – for example, under certain litigation funding arrangements
- Change of control event or initial public offering – for example, redemption and conversion features in debt instruments that are exercisable based on the occurrence or nonoccurrence of such events if those events are determined to be the predominant underlying
The proposal also would provide that an entity is not required to consider whether such events are within its control in determining whether the contract qualifies for the proposed scope exception. In addition, when assessing whether an underlying is specific to a party to the contract, the scope exception could be met if the underlying was specific to any entity within a consolidated group.
The proposed scope exception would not apply to features based on market rates, market indexes, or the price or performance of a financial asset or financial liability.
Crowe observation: We expect the proposal will have a broad impact on the assessment of conversion and redemption features in debt instruments and preferred shares that are considered debt host contracts for the purposes of evaluating embedded derivatives. This is because many of those features become exercisable upon events (such as an initial public offering or change of control) that would qualify for the proposed scope exception. As an example, a redemption feature that is exercisable upon a change of control and that settles at a significant discount to par would be bifurcated and accounted for separately as a derivative under Topic 815’s current guidance. Under the proposal, the redemption feature could qualify for the proposed scope exception depending on the outcome of the proposed changes to the predominant characteristics assessment as covered here.
Predominant characteristics assessment
The proposal would amend how an entity assesses a contract with multiple underlyings when some, but not all, of the underlyings qualify for an exception to the derivative scoping guidance provided in paragraph 815-10-15-59. Current guidance requires entities to assess predominance by determining if all underlyings, considered in combination, are highly correlated to underlyings that do not qualify for an exception in paragraph 815-10-15-59. This approach has resulted in both uncertainty and complexity in application.
Under the proposed amendments, an entity would determine a contract’s predominant characteristics by identifying the underlying with the greatest expected impact on changes in the contract’s fair value. If that underlying qualifies for an exception in paragraph 815-10-15-59, the contract would not be accounted for as a derivative. If it does not, the contract would be accounted for as a derivative.
The revised predominant characteristics assessment also would apply to features embedded in hybrid instruments. Entities would determine the need for bifurcation of an embedded feature with multiple underlyings (when some, but not all, of the underlyings qualify as scope exceptions) by identifying the underlying with the greatest expected impact on the fair value of the embedded feature. As an example, assume a redemption feature embedded in a debt instrument is exercisable upon a change of control of the issuer. The feature would qualify for the proposed exception if the probability of a change of control is expected to have an effect on the changes in fair value of the feature that is greater than that of other underlyings that do not qualify for an exception (for example, interest rates).
The predominant characteristics assessment would be made at the time of contract inception only. However, in the event that the most prevalent underlying is resolved and multiple underlyings remain, an entity would reassess the predominant characteristic of the contract based on the remaining underlyings.
Crowe observation: While the proposed additions to the scope exceptions in paragraph 815-10-15-59 would result in fewer derivatives required to be measured at fair value through earnings, the proposal notes that other GAAP would apply to contracts and features no longer within the scope of Topic 815. The proposal references the following contracts and applicable GAAP when Topic 815 does not apply:
- R&D funding arrangements under Subtopic 730-20, “Research and Development – Research and Development Arrangements”
- ESG features in debt instruments under indexed debt guidance in Subtopic 470-10, “Debt – Overall”; the structured note guidance in Subtopic 320-10, “Investments – Debt Securities – Overall”; or Topic 450, “Contingencies”
- Litigation funding arrangements under Subtopic 450-20, “Contingencies – Loss Contingencies”
Although none of the referenced alternative guidance requires fair value measurement, such guidance might require an entity to monitor expected cash flows under the contract in order to meet another prescribed measurement objective. For example, a company might be required to estimate and accrue a charge for a contract in the scope of Topic 450 if 1) there is information available that indicates that it is probable that a liability had been incurred at the reporting date and 2) the amount of the loss can be reasonably estimated.
Share-based payments in a contract with a customer
The proposal also addresses how an entity that receives share-based consideration in a contract with a customer would account for the share-based payments (for example, shares and options [warrants] and forward contracts on shares). Current guidance does not specifically indicate which guidance an entity should apply to record the share-based payment received. Because of this, stakeholder feedback indicated that it is unclear whether the entity should recognize the share-based consideration received upon contract inception (under Topic 815 or Topic 321) or upon the fulfillment of the performance obligation (under Topic 606).
Proposed changes to Topic 606 would clarify that an entity that receives a share-based payment from a customer in return for goods or services should first apply Topic 606. That is, prior to applying any other topics (for example, Topic 815 or Topic 321) to the share-based payment, an entity would first apply Topic 606’s guidance on noncash consideration, recognizing the share-based payment received as an asset only upon the associated performance obligation being satisfied.
The proposal also would amend Topic 815 and Topic 321, “Investments – Equity Securities,” to clarify that an entity would not apply the guidance within these topics unless and until any share-based payment is recognized as an asset under Topic 606.
Transition
Transition requirements differ for separate components of the proposed ASU.
- For amendments related to accounting for the receipt of share-based payments in a revenue contract, entities would apply the guidance to revenue contracts that exist as of the beginning of the fiscal year of adoption through a cumulative-effect adjustment to opening retained earnings as of the beginning of the fiscal year of adoption.
- For all other amendments, entities would apply the guidance prospectively or elect to apply the same approach as required for the amendments related to share-based payments.
Entities also would be permitted a one-time election to apply the fair value option for any contracts that previously were accounted for as derivatives but that no longer would qualify as such due to the amendments.
Early adoption would be permitted for all proposed amendments.
Comments on the proposal are due Oct. 21, 2024.
