Remarks before the 2014 AICPA National Conference on Current SEC and PCAOB Developments
Hillary H. Salo
Professional Accounting Fellow, Office of the Chief Accountant
Dec. 8, 2014
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.
Good morning. Today I would like to share with you some views on a couple of recent financial instrument issues.
Impact of Derivative Novations on Hedge Accounting
First, I would like to discuss the impact of a derivative instrument’s novation on an existing hedging relationship. To provide some context for this issue, it is important to note that the novation of a derivative instrument, where one counterparty is replaced with another, may be initiated by either party to the instrument and normally requires both parties’ consent. Further, the staff understands that a novation is generally viewed as the legal termination of the original derivative instrument and the entering into of a new derivative instrument.
Topic 815[i] states that an entity is required to prospectively discontinue hedge accounting if the designated derivative instrument is terminated.[ii] It also states that if any of the critical terms of the hedging relationship documented at hedge inception change, an entity must dedesignate the original hedging relationship and redesignate a new hedging relationship.[iii]
Therefore, while a derivative instrument novation may not be economically significant if, for example, the creditworthiness of both the original and new counterparty is similar, the effect on existing hedging relationships should be considered. For instance, if a derivative instrument novation results in a termination of the existing hedging relationship, it could cause an entity to no longer qualify for hedge accounting going forward because the novated derivative instrument may have a fair value other than zero on the redesignation date.
In 2012, the staff provided guidance related to how certain reforms to the OTC derivatives market under the Dodd-Frank Act[iv] may affect existing hedging relationships.[v] Under that guidance, the staff indicated that it would not object to a conclusion for accounting purposes that the original derivative contract had not been terminated and replaced with a new derivative contract, nor would the staff object to the continuation of the existing hedging relationship in the following circumstances:
- For an OTC derivative transaction entered into prior to the application of the mandatory clearing requirements, an entity voluntarily clears the underlying OTC derivative contract through a central counterparty, even though the counterparties had not agreed in advance that the contract would be novated to effect central clearing;
- For an OTC derivative transaction entered into subsequent to the application of the mandatory clearing requirements, the counterparties to the underlying contract agree in advance that the contract will be cleared through a central counterparty in accordance with standard market terms and conventions and the hedging documentation describes the counterparties’ expectations that the contract will be novated to the central counterparty; or
- A counterparty to an OTC derivative transaction who is prohibited or is expected to be prohibited from engaging in certain types of derivative transactions novates the underlying contract to a consolidated affiliate that is not insured by the FDIC and does not have access to Federal Reserve credit facilities.
In addition to the circumstances addressed in this guidance, the staff has received a number of questions related to the impact of derivative instrument novations on existing hedging relationships in other fact patterns. In that regard, provided that no other critical terms of the derivative instrument have been changed, the staff has also not objected to an entity continuing to apply hedge accounting upon a derivative instrument’s novation when:[vi]
- The reporting entity’s derivative counterparty merges with and into a surviving entity that assumes the same rights and obligations that existed under a pre-existing derivative instrument of the merged entities;
- The reporting entity’s derivative counterparty novates a derivative instrument to an entity under common control with the derivative counterparty; or
- At the inception of the hedging relationship, the reporting entity knows and contemporaneously documents that all or part of the derivative will be novated to a new counterparty during the hedging relationship.[vii]
As we advised when providing the staff’s views, these views are not intended to be applied by analogy. Therefore, if a reporting entity’s circumstances differ from those mentioned today, the staff would encourage consultation with OCA before continuing to apply hedge accounting upon a derivative novation.
Allocation of Proceeds when the Fair Value of a Liability Required to be Measured at Fair Value Exceeds the Net Proceeds Received for a Hybrid Instrument
Next, I would like to turn to a question we have received involving the allocation of proceeds when a reporting entity issues a hybrid instrument and the fair value of the financial liabilities required to be measured at fair value exceeds the net proceeds received. I think you would all agree that this issue is far more fascinating than derivative novations.
Now, the first question you are likely asking yourself is “How can that happen and why would they do that?”, which is completely logical given you wouldn’t expect a party to an arm’s length transaction to accept proceeds that are less than the fair value of the financial instruments being exchanged. However, the staff understands that there are substantive reasons reporting entities may enter into these types of arrangements, including circumstances in which alignment with a particular investor is viewed as beneficial to the reporting entity or because a reporting entity is in financial distress and requires financing. For example, assume a reporting entity that wants to align itself with a specific investor issues $10 million of convertible debt at par and is required to bifurcate an in the money conversion option with a fair value of $12 million. In this case, the fair value of the financial liability required to be measured at fair value (that is, the embedded derivative) exceeds the net proceeds received under the transaction.
US GAAP provides allocation guidance for certain types of transactions. For instance, Topic 815 requires reporting entities to record an embedded derivative at fair value and assign the remainder of the proceeds to the carrying value of the host contract.[viii] In addition, Topic 470[ix] requires that proceeds from the sale of a debt instrument with equity-classified detachable warrants be allocated between the two elements based on their relative fair values.[x] However, for those transactions where the hybrid instrument is not issued at fair value, and the financial liabilities required to be measured at fair value exceed the net proceeds received, the staff acknowledges that judgment is required to determine the allocation of proceeds.
As a result, the staff believes that when reporting entities analyze these types of unique fact patterns, they should first, and most importantly, verify that the fair values of the financial liabilities required to be measured at fair value are appropriate under Topic 820.[xi] If appropriate, then the reporting entity should evaluate whether the transaction was conducted on an arm’s length basis, including an assessment as to whether the parties involved are related parties under Topic 850.[xii] Lastly, if at arm’s length between unrelated parties, a reporting entity should evaluate all elements of the transaction to determine if there are any other rights or privileges received that meet the definition of an asset under other applicable guidance.
In the fact patterns analyzed by the staff, we concluded that if no other rights or privileges that require separate accounting recognition as an asset could be identified, the financial liabilities that are required to be measured at fair value (for example, embedded derivatives) should be recorded at fair value with the excess of the fair value over the net proceeds received recognized as a loss in earnings. Furthermore, given the unique nature of these transactions, we would expect reporting entities to provide clear and robust disclosure of the nature of the transaction, including reasons why the entity entered into the transaction and the benefits received.
Additionally, some people may wonder whether the staff would reach a similar conclusion if a transaction was not at arm’s length or was entered into with a related party. We believe those fact patterns require significant judgment; therefore, we would encourage consultation with OCA in those circumstances.
That concludes my prepared remarks. Thank you for your attention.
[i] ASC Topic 815, Derivatives and Hedging
[ii] Refer to ASC 815-25-40-1(b) and ASC 815-30-40-1(b).
[iii] Refer to ASC 815-20-55-56.
[iv] Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
[v] May 11, 2012 letter from the Office of the Chief Accountant to the International Swaps and Derivatives Association.
[vi] Changes in the creditworthiness of a derivative counterparty may change the fair value of the derivative instrument and impact the reporting entity’s assessment of effectiveness and measurement of ineffectiveness of the hedging relationship. Only hedging relationships that continue to be highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the term of the hedging relationship continue to qualify for hedge accounting.
[vii] This includes derivative counterparties that voluntarily clear transactions through a central counterparty even though not required under Dodd-Frank or other legal or regulatory framework.
[viii] Refer to ASC 815-15-30-2.
[ix] ASC Topic 470, Debt
[x] Refer to ASC 470-20-25-2.
[xi] ASC Topic 820, Fair Value Measurement
[xii] ASC Topic 850, Related Party Disclosures