If you were confused over the complexity of derivative and hedging rules as it relates to recent chaos in credit markets, perhaps the latest clarification from the Financial Accounting Standards Board will help clear things up.

FASB published Accounting Standards Update No. 20101-11 – Derivatives and Hedging (Topic 815): Scope Exception Related to Embedded Credit Derivatives to try to clarify how embedded credit derivative features should be treated in such exotic financial instruments as collateralized debt obligations and synthetic CDOs. FASB heard a flurry of questions and confusion over how to treat certain embedded credit derivatives as credit markets tanked and companies struggled with how to value toxic, debt-based instruments such as CDOs and others.

The guidance is intended to address uncertainty over a scope exception that is already provided for embedded credit derivatives in existing hedge accounting rules (specifically, paragraphs 815-15-15-8 through 15-9 of the Accounting Standards Codification). The guidance tries to explain in what kind of contracts the embedded credit derivative scope exception applies and in what kind of contracts it does not apply. The difference is important because in some cases the embedded credit derivative is subject to bifurcation, or extraction from the host contract, so that it gets separate accounting treatment.

The new rule calls out three specific instances where the embedded credit derivative likely still requires separate accounting, despite any apparent exceptions that are provided in Generally Accepted Accounting Principles. The three instances focus attention on establishing where there may be risk and who may be exposed to it.

FASB said it is providing the clarifications and related additional examples to help resolve potential ambiguity about the breadth of the embedded credit derivative scope exception provided elsewhere in GAAP. The guidance is effective for the first quarter beginning after June 15, 2010, with early adoption permitted.

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