Changes in determining how loans
will be scoped in bring guidance closer to the statement
itself, as more issues achieve closure.
At its meeting on December 19, the Board
agreed to the staff's recommendation to change its final
guidance on the application of FAS 133 to loans (and
other credit arrangements): i.e., when they should be
defined as derivatives for accounting purposes. The
Board thus decided to override C13,"When a Loan Commitment is
Included in the Scope of Statement 133," with broader
guidance utilizing FAS 133's characteristic-based
definition of a derivative (in particular, the
net-settlement criteria found in paragraph 9b).
Under this approach, loans and other
off-balance sheet credit arrangements that meet the
statement's definition of a derivative would be scoped
in. However, the key to this approach is to be found in
the language the staff has drafted to help apply the FAS
133 definition of a derivative to such loans/credit
arrangements. This language, which we understand will
set a relatively high hurdle for loans to meet the 9b
test, is to be posted on the FASB site soon, and
subjected to a 35-day comment period. [There may be two
issues: one to clarify the market mechanism need to
qualify for 9b (net settlement) and a second to address
the application of the derivative definition in
accounting of the loan.]
Clarification on the question of MAC
clauses (not to be considered) and asymmetrical
accounting for borrower and lender (allowing borrowers
to continue to account for loans deemed derivatives for
banks as loans) as discussed below will also be included
in the guidance posted to the FASB website. Notice will
be given that the resulting guidance will be conditioned
on amendments to Statements 65 and 91, which covered prior loan
accounting.
Desperate for closure, the board stresses
that this is essentially the final answer on the
subject, and it will primarily consider comments that
help improve the application of the derivative
definition test. Note that this change sets a further
precedent for seeking changes to existing, pre-cleared
guidance that go back to the conceptual foundation of
the statement itself.
Another issue of large concern to the
electricity industry was the Board's discussion of
further revisions to C15,
"Normal Purchases and Sales Exception for Option-Type
Contracts and Forward Contracts in Electricity." In
October, the staff revised C15 to clarify the unique
nature of capacity contracts in the electrical industry
and define criteria under which contracts with certain
option features and bookouts can qualify for the normal
purchases and sales exception. The Board has given the
final go- ahead, approving staff revisions which means
C15 will be posted in its final form very soon. We are
unclear as to what extent, if at all, these revisions
will differ from the October 10 draft, but interested
parties will want to scrutinize the words carefully.
Prior to today's meeting, this
issue had been addressed, in part, with C13, "When a
Loan Commitment is Included in the Scope of Statement
133," which was posted as tentative guidance on the FASB
website in January 2001. C13 provided that (1) loan
commitments that relate to the origination or
acquisition of mortgage loans that will be held for
resale under Statement 65 must be accounted for as
derivatives under Statement 133 by both the borrower and
lender; (2) loan commitments that relate to the
origination or acquisition of mortgage loans that will
be held of investment continue to be accounted for under
Statement 65 and (3) commitments that relate to the
originations of non-mortgage loans continue to be
accounted for under Statement 91.
However, C13 dealt mainly with mortgage
loans, which would have required FASB to consider
extending the guidance in C13 to non-mortgage loans held
for resale.
As an alternative, the staff had
recommended the Board switch gears and use the
Statement's broader guidance on defining derivatives to
determine when loans are scoped in, which the Board
accepted.
A third and fourth alternative were also
presented but not widely considered. The first of these
would have imposed the need for both parties of a
contract to have access to a market mechanism, in order
for the contract to meet the paragraph 9b net settlement
criteria. Going down this route would require a similar
decision by the board on this "both counterparty"
requirement for all 9b tests. The second of these
alternatives suggested the Board simply carve out a
specific subset of loans from FAS 133.
In discussing this question, one of the
board members noted how divisive this issues was in the
financial services industry, with constituents coming
down almost equally on both sides (see I-bank
vs. C-bank debate). This prevented easy
consideration of a carve out, or any guidance, that
drifted away from FAS 133's conceptual fundamentals.
The guidance in C13 (formerly E13) was
already drifting away from the core FAS 133 concepts,
but this reflected the Board's mistaken view that most
all loan commitments were clearly not derivatives.
However, C13 arose out of discussions at the DIG (see
Item 11-4 discussions here
and here)
where DIG members pointed out market mechanisms that
could emerge to facilitate net settlement in loans and
how loans with option features were included in
Statement 119 disclosure guidelines.
Moreover, C13 was potentially holding back
the planned move to a fair value model for all financial
instruments--a project discussed later at the meeting.
As one of the new board members, Katherine Schipper, pointed out, going
with the alternative to C13 not only provides an
opportunity to fix a flawed approach to loan scope outs,
but it brings GAAP further in the direction of the fair
value model toward which the FASB is moving. Though,
other board members, and the staff, said it was not
clear whether more or fewer loans would be likely to be
scoped in under the agreed upon C13 alternative.
Having reached on consensus on the first
question concerning loans, the Board turned to the
second and third questions framed by the staff.
Question 2 dealt with the effect of a
subjective material change clause (Ma clause that may be
invoked by the issuer based oive evaluation of the
adverse change-on whethoped into FAS 133. Though not
explicitly stated, this question was posed in order to
prevent the insertion of MAC clauses into credit
arrangements merely to trigger a scope exception.
The alternative guidance proposed by the
staff dealt with the degree of control the issuer has
over the MAC trigger:
Alternative 1 states that the
existence of a subjective MAC clause always causeso be
excluded from the scope of the staff's proposed
guidance.
Alternative 2 would have the loan
excluded only if it is remote that the issuer would
invoke the MAC clause.
Alternative 3 would ignore the MAC
altogether and not use it as a consideration in
excluding the contract.
The board had no objections to the
staff recommendation to ignore the MAC clause
(alternative 3).
The third question arising from the loan
discussion asked if asymmetrical accounting would be
allowed for loans falling under the scope of FAS 133. In
other words, a market mechanism might exist for the
issuer (lender), but not the holder (borrower), which
would make the contract a derivative from the former's
perspective but not the latter's.
As a pure practical matter, the Board
concluded that asymmetrical accounting would be allowed
on an exception basis where the holder (borrower) does
not account for the contract as a derivative--even where
it meets the test for the issuer (lender).
Otherwise, borrowers would have to phone their lenders
and ask how they were accounting for the loan in order
to arrive at proper accounting.
In what might be labeled year-end clean
up, the Board cleared to Issues of relatively minor
importance. J19, "Application of the Normal
Purchases and Normal Sales Exception on Initial Adoption
to Certain Compound Derivatives" is a transition issue
and has become a moot point now that most people have
adopted FAS 133 and proceeded through the initial
transition phase. Following procedure the Board cleared
this issue, just to bring finality to the subject.
The second, B34, "Period-Certain Plus
Life-Contingent Variable-Payout Annuity Contracts with a
Guaranteed Minimum Level of Period Payments," dealt with
an unresolved question in B25.
The staff response in B34 was that:
the embedded derivative related only to
the period-certain guaranteed minimum periodic payments
would be required to be separated under paragraph 12,
whereas the embedded derivative related to the
life-contingent guaranteed minimum periodic payments
would not be separated under paragraph 12. Separate
accounting for the embedded derivative related only to
the period-certain guaranteed minimum periodic payments
would be required even if the period-certain plus
life-contingent annuity, in its entirety, meets the
definition of an insurance contract under paragraph 8 of
Statement 97 and has no withdrawal features.
This conclusion is based on the
premise that the guaranteed floor payment is not clearly
and closely related to the host contract (a
variable-payout annuity contract) and, thus, must be
bifurcated. This is consistent with the guidance in
Statement 133 Implementation Issue No. B8,
Identification of the Host Contract in a Nontraditional
Variable Annuity Contract." However, the life-contingent
portion of the variable-annuity that has no withdrawal
features would not be subject to the requirements of
Statement 133 because the contract meets the paragraph
10(c) exception. Thus, no separate accounting is
required under paragraph 12 for the embedded derivative
related to the guarantee that each life-contingent
periodic payment will not be less than a specified
minimum.
The Board affirmed this response,
clearing B34. However, in the discussion the Board
members noted that the rationale used in applying
paragraph 10c to allow the insurance exemption was more
the result of death than the insurance definition in Statement
97, which should have been recognized in the
discussion of B25. For this reason, board members asked
that the rationale language be taken out and that the
staff keep B34 separate from B25 to highlight the
rationale nuances.