On March 11, 2016, the Financial Accounting Stability Board (FASB) issued accounting guidance on Derivatives and Hedging (Topic 815). The guidance addresses accounting standards related to:

Entities that enter into certain derivatives contracts to hedge a part of their business may, in certain circumstances, utilize hedge accounting for the transaction. Hedge accounting allows entities to avoid large fluctuations in their overall profit and loss that directly result from the daily mark-to-market requirement applicable to most derivatives.

A novation occurs when one party to an existing derivatives transaction is replaced with another party, and may happen when a variety of events occur, including, among others:

Under previous guidance, it was unclear what effect the novation of a derivatives contract by an entity's counterparty (party B) would have on the entity's (party A's) accounting treatment of the transaction, and specifically whether a novation would require a departure from hedge accounting for the transaction for party A.

Under the new guidance, FASB makes clear that a change in the counterparty to a derivatives instrument that has been designated as a hedging instrument under Topic 815, will not, by itself, require that the transaction be de-designated as a hedging instrument. However, to retain treatment as a hedging instrument, the transaction must continue to comply with all other hedge accounting criteria.

FASB Topic 815 (Derivatives and Hedging) requires that embedded derivatives (generally, a put or call option that is included in a "host" contract – usually a debt security such as a bond or note) be separately accounted for from the host contract and accounted for as a derivative, if certain criteria are met. Among other things, if the economic characteristics and risks of the embedded derivative are not "clearly and closely related" to the economic characteristics and risks of the host contract, the host contract and the derivative must be accounted for separately.

For contingent put and call options that can accelerate the repayment of debt to be considered "clearly and closely related" under current FASB guidance (and therefore not separated for accounting purposes), the option must be indexed to interest rates or credit risk.

In response to interpretative questions raised about the guidance, the FASB Derivatives Implementation Group (DIG) has attempted to clarify through implementation guidance in a four-step "decision sequence" applicable to all put and call options. The sequence requires an entity to consider whether:

If the answer to all of the above is yes, then the embedded option is "clearly and closely related" to the host contract under current FASB guidance, and therefore not separated for accounting purposes.

However, questions have emerged among market participants regarding exactly how the four-step sequence is to be applied to a transaction and how it interacts with the original guidance for accounting for put and call options. Specifically, industry participants have taken two divergent approaches:

This guidance eliminates the second approach and clarifies that, in order to meet the "clearly and closely related" standard, an entity must only engage in the four step analysis and need not examine the event that triggers the ability to exercise the put and call option.

Adherence to this guidance is required in financial statements:

Additionally, this guidance should be applied using a modified retrospective approach as of the beginning of the fiscal year for which the amendments are effective, described in detail in each respective guidance.