Put and Call Options Updated by FASB

An accounting standards update has been issued by the Emerging Issues Task Force Financial Accounting Standards Board for ‘put and call’ contingent debt instrument options. According to FASB, the prevailing standards for hedging and derivatives require separation of embedded derivatives from an individual host contract and separately accounted for as derivatives if some certain criteria has been met. Among the criteria is if the risks and economic characteristics of the derivatives embedded are not closely and clearly related to the risks and economic characteristics of the host contract.

Already, the U.S GAAP offers assessment guidance for the assessment if the put (call) options that may accelerate repayment of principal on a debt instrument is able to meet the ‘closely and clearly’ related criteria. According to the guidance, in order to closely and clearly consider the contingent put (call) options to be related closely, they may only be indexed to credit risk or interest rates.

Nonetheless, some questions arose from this guidance in the interpretation tried by FASB’s Derivatives Implementation Group in their bid to clarify through guidance implementation in a sequence of four step decision for every put (call) options. This sequence expects an organization to consider if the payoff is adjusted depending on change indexing. Apart from credit risk or interest risk, the payoff is indexed; the debt also entails a significant discount or premium.

There have been new questions that have emerged regarding how the 4 step decision sequence is able to interact with the initial guidance for assessing the contingent call embedded in debt instrument options. In practice, two different approaches have been developed. In the first approach, the assessment if contingent put or call option are closely and clearly related to the debt host calls for the four step sequence decision. In the second approach, there is an assessment if the even triggering the exercising ability of call and put option is indexed to credit risk and interest rates is needed besides the sequence of the four step decision. The challenge is that these two approaches may result to varying conclusions about if the embedded put or call options should be accounted for or bifurcated separately as derivatives.