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Journal entry — EITF — FASB issues two proposed ASUs in response to EITF consensuses-for-exposure

Published on: Oct 23, 2013

Today, the FASB issued the following proposed ASUs in response to consensuses-for-exposure reached at the EITF’s September meeting (see Deloitte’s September EITF Snapshot for more information):

Comments on the proposed ASUs are due by December 23, 2013.

Proposed ASU on Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved After the Requisite Service Period

Under this proposal, entities would be required to treat a performance target that could be achieved after an employee’s requisite service period as a performance condition that affects vesting (and is not reflected in the estimation of the fair value of the award as of the grant date). In short, compensation cost would not be recognized until it becomes probable that the performance target will be achieved. In addition, the amount of compensation expense that the entity recognizes would “reflect the number of awards that are expected to vest and would be adjusted to reflect those awards that ultimately vest.”

Background: The definition of performance condition in the Codification Master Glossary states that such a target “is defined solely by reference to the employer’s own operations (or activities)” and may include “[a]ttaining a specified growth rate in return on assets, obtaining regulatory approval to market a specified product, selling shares in an initial public offering or other financing event, . . . [or] a change in control.” It “may [also] be defined by reference to the same performance measure of another entity or group of entities” or “pertain either to the performance of the entity as a whole or to some part of the entity, such as a division or an individual employee.” A performance condition affects “the vesting, exercisability, exercise price, or other pertinent factors used in determining the fair value of an award that relates to both of the following:
  1. An employee’s rendering service for a specified (either explicitly or implicitly) period of time
  2. Achieving a specified performance target.”

While the definition of a performance condition refers to both a service requirement and a performance target, the FASB’s proposed ASU based on EITF Issue 13-D would require entities to treat performance targets that could be met after the service period as performance conditions that affect vesting. The proposal applies equally to awards for both retirement-eligible employees and employees that would not become retirement-eligible during the award’s standard service period.

The proposal would not require entities to provide any incremental recurring disclosures and would be applied prospectively to awards that are granted or modified on or after the final ASU’s effective date. The Task Force will discuss the effective date at a future meeting; however, early adoption would be permitted.

Proposed ASU on Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity

This proposal would prohibit entities from applying the chameleon approach1 when evaluating the nature of the host contract in a hybrid financial instrument issued in the form of a share to determine whether features embedded in the contract are clearly and closely related to the host.2 Therefore, as indicated in the proposal, entities would be required to “determine the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid financial instrument, considering each term and feature on the basis of the relevant facts and circumstances.” In short, entities would be (1) required to apply the whole-instrument approach3 when determining the nature of the host contract in a hybrid financial instrument issued in the form of a share and (2) prohibited from presuming that a redemption feature is determinative in the conclusion that a convertible preferred share with a redemption feature is more akin to debt than to equity.

Background: Although the chameleon and whole-instrument approaches are not specifically addressed in U.S. GAAP, they are currently considered appropriate as long as an entity makes an accounting policy election to consistently apply the approach it selects. These two approaches developed in practice in response to an SEC staff announcement codified in ASC 815-10-S99-3,4 which states, in part, that an entity must consider all “stated and implied substantive terms and features” of a hybrid instrument issued in the form of a share when determining the nature of the economic characteristics and risks of the host contract. However, the staff also acknowledged that some registrants have an accounting policy in which the terms and features pertaining to the individual embedded derivative being evaluated are excluded from the determination of the nature of the host contract for that embedded derivative. The SEC staff will consider rescinding this announcement if the proposal is finalized.

The EITF will discuss whether to finalize this proposal, as well as what its effective date should be, at a future meeting but has reached a consensus-for-exposure on the guidance’s transition. An entity (an issuer or investor) would be required to assess any hybrid instrument issued in the form of share that it holds on the effective date to determine whether (1) an embedded feature that was not previously bifurcated should be bifurcated or (2) a previously bifurcated embedded derivative should no longer be bifurcated. The entity would report the effects of any change in its accounting for hybrid financial instruments issued in the form of a share as a cumulative-effect adjustment to beginning retained earnings in the year of adoption. The carrying values of previously bifurcated embedded features and their host contracts would be combined as of the date of adoption, and no cumulative-effect adjustment would be required. For embedded derivative features that the entity did not bifurcate before adopting the guidance in the proposal but that would be bifurcated as a result, an entity would calculate the carrying value of the now-bifurcated embedded derivative feature and the host contract as of the date of adoption by assuming they had been bifurcated at initial recognition of the hybrid financial instrument. The differences in the carrying value of the hybrid instrument before adoption and the cumulative carrying amount of the embedded derivative feature and the host contract would be recorded as an adjustment to beginning retained earnings. Early adoption would be permitted.

Although these proposed amendments are not final and consequently still subject to change, entities that had previously applied the chameleon approach or that had bifurcated embedded derivatives from hybrid financial instruments issued in the form of a share under the whole-instrument approach should follow these developments closely since they may need to change their previous accounting conclusions once the ASU is finalized. Entities are encouraged to consult with their professional accounting advisers, particularly when first establishing an accounting policy for these instruments or changing existing accounting policies (in which case a preferability analysis may be required). If the proposed ASU is finalized without modification, it will continue to be inappropriate to determine the nature of the host for these instruments without analyzing the relevant terms and features of the hybrid financial instrument (e.g., by using the pure-host approach5).

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1 Under the chameleon approach, an entity determines the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid instrument, except for the particular embedded feature being analyzed for bifurcation. When the chameleon approach is used to analyze a hybrid instrument with multiple embedded features, the nature of the host contract may change as each embedded feature is analyzed separately.

2 Entities may be required to account for features embedded in a financial instrument separately if (1) the features are not clearly and closely related to the host contract, (2) the hybrid financial instrument is not measured at fair value with changes in fair value recognized in net income, and (3) a freestanding derivative with terms similar to those of the embedded feature meets the definition of a derivative under ASC 815.

3 Under the whole-instrument approach, an entity determines the nature of the host contract by considering all stated and implied substantive terms and features of the hybrid instrument, including the embedded feature being analyzed for bifurcation. When the whole-instrument approach is used to analyze a hybrid instrument with multiple embedded features, the nature of the host contract should not change as each embedded feature is analyzed separately.

4 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”

5 As noted in the FASB staff’s Issue Summary, “[u]nder the pure-host approach, an entity determines the nature of the host contract by excluding all embedded derivative features. All remaining terms and features would be analyzed to determine the nature of the host contract. An entity would then individually compare each embedded derivative feature to the host contract to determine whether the embedded derivative feature is clearly and closely related to the host contract.”

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