Capital Markets

FASB To Change Derivative Accounting

FASB aims to eliminate the income statement volatility from asset-backed derivatives.
Helen ShawOctober 25, 2006

The Financial Accounting Standards Board voted on Wednesday to push ahead a proposed change aimed at easing the volatility in the income statements of asset-backed and mortgage-backed securities investors—such as community banks and insurance companies.

The proposal would affect FASB Statement No. 133, Accounting for Derivatives Instruments and Hedging Activities, and allow companies not to account for embedded derivatives that are associated only with prepayment risk.

MBSs have derivative-like qualities because their value changes when consumers prepay their loans or when interest rates change, possibly resulting in a lower-than-expected return for the holder of those securities. Currenlty, investors must account for the fair value of their investment every quarter in their financial reports. Under the new accounting proposal, the investor’s net income will only be affected when it sells a security with an embedded derivative; interim changes will not need to be recorded. As a result, says FASB, there will be less income statement volatility tied to interest-rate gains or losses for asset-backed securities holders.

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The FASB voted six to one to issue the proposal, explained Russell Golden, a senior technical advisor at FASB. Ed Trott, FASB board member and a former KPMG partner, dissented and will write an alternative view.

FASB undertook the change to address concerns about prepayment risk causing confusion over embedded derivatives in MBSs and ABSs, added Golden. The board’s other options, including issuing further guidance, would have had the same result for preparers as the “scope exception” it undertook today, he said. The change will take effect after the beginning of a company’s first fiscal year after September 15, 2006.

There will be a 30-day comment period for the proposed scope-out. The board expects to finalize the proposal by late December and vote on it in early January, said Golden.