FASB Recalibrates Derivative Scoping in ASC 815

Introduction

On July 23, 2024, the Financial Accounting Standards Board (FASB or Board) issued a proposed Accounting Standards Update (ASU) intended to improve derivative accounting. The proposed update would change the scope of Accounting Standards Codification (ASC) 815, Derivatives and Hedging by clarifying that certain types of contracts should not be accounted for as derivatives. It also provides guidance on how to account for share-based payments from customers, specifying that firms should first evaluate such payments using the guidance in ASC 606, Revenue from Contracts with Customers before using other topics such as ASC 815 or ASC 321.

The proposal responds to stakeholders’ concerns that derivative accounting is being too broadly applied in practice. This issue is especially relevant for certain emerging transactions and other arrangements that have contingent payouts based on an entity’s own operational outcomes, such as sustainability-linked bonds loans or bonds, litigation funding agreements, and research and development (R&D) funding arrangements. In some cases, entities are treating these contracts or their embedded contingent features as derivatives even when derivative accounting does not accurately represent the underlying economics.

Stakeholders such as accounting firms, preparers, and CPA societies submitted comment letters generally expressing support for the direction of the proposed guidance with targeted suggestions of how to improve it. These opinions are summarized later in this article. After discussing the feedback received and deciding on appropriate changes, the FASB is now working on a final ASU for issuance to the public.

This article critically evaluates why derivative scoping can be so complex, the FASB’s proposed solution, stakeholder feedback on the issue, and potential implications and future considerations related to derivatives and financial reporting.

Challenges of Derivative Scoping

ASC 815 is one of the longest and most complex sections of the Codification. Its “Scope and Scope Exceptions” section alone spans 142 paragraphs, many of which contain multiple sub-paragraphs. Before arriving at the definition of a derivative, the guidance works through at least 15 scope exceptions that could exempt a contract from being considered a derivative.

The FASB shares in its Basis for Conclusions that stakeholders have expressed that the analysis required to determine if a contract is within the scope of ASC 815 creates “significant costs,” and that even for contracts that do not meet any scope exceptions, the actual derivative accounting can be challenging to apply. Some firms may even avoid entering contracts that could potentially qualify as derivatives to avoid derivative accounting¹.

A key area of difficulty the FASB is addressing in its current project involves determining whether contracts with contingent features based on a firm’s operations fall within the scope of ASC 815 and should be accounted for as derivatives². This applies specifically to “certain contracts that are not traded on an exchange," discussed in paragraphs 815-10-15-59 through 815-10-15-62. These paragraphs include a list of exclusions that do not clearly and obviously scope out all emerging contracts or emerging interpretations of contracts not meant to be treated as derivatives. They also state that if a contract contains a variable that does not meet any of the specific exclusion criteria, it may still be considered a derivative if it meets the broader definition³. The language and structure of the guidance can therefore make it difficult to definitively conclude that a contract is outside the scope, even when derivative accounting is not the best fit for the transaction.

Stakeholders, including public accounting firms, accounting advisory firms, industry associations, banks, and other preparers and practitioners have brought concerns to the FASB about ESG-related transactions and other arrangements that can involve derivative classification despite having economic characteristics more consistent with other accounting models. Below are a few specific examples of the types of transactions these stakeholders are concerned about:

Contract Type	Description	How It Might Be a Derivative	Other Applicable Topics⁴
Sustainability-linked bonds	Bonds where the issuer agrees to adjust the coupon rate based on whether it meets pre-defined ESG performance targets (e.g., reducing emissions, improving diversity). If targets are not met, the coupon typically increases; if met, it may decrease. See this ESG Reporting Hub article on sustainability-linked bonds for more information.	The ESG-linked feature may not be clearly and closely related to the debt host, which could require bifurcation. The underlying is the ESG performance metric. The feature may involve no initial net investment and changes in interest payments could be net settled.	Subtopic 470-10, Debt—Overall Subtopic 320-10, Investments—Debt Securities—Overall Topic 450, Contingencies
Litigation funding arrangements	Contracts in which a firm provides funds to a plaintiff pursuing legal action. In return, the funding firm receives a portion of the proceeds if the suit is successful but may receive nothing if the suit is unsuccessful.	These arrangements may include features with underlyings tied to the outcome of legal proceedings. If the initial investment is small relative to the potential payout, the feature may resemble a call option.	Subtopic 450-20, Contingencies—Loss Contingencies
R&D funding arrangements	Contracts in which an investor provides capital to fund a firm’s research and development activities. Repayment is contingent on achieving certain milestones, regulatory approval, or other pre-determined outcomes.⁵	Repayment triggers may qualify as underlyings. From an accounting perspective, these contingent features may resemble call options if they give the investor the right to receive repayment based on defined events.	Subtopic 730-20, Research and Development—Research and Development Arrangements

As these examples illustrate, ASC 815 could potentially apply to both emerging ESG-related transactions (sustainability-linked bonds) as well as more established transactions (R&D funding arrangements or litigation funding arrangements). In practice, this could confuse investors about the purpose of these transactions, create additional accounting costs for preparers, and result in unnecessary earnings volatility or distorted financial ratios.

FASB’s Proposed Solution

To address concerns that certain contracts are being inappropriately accounted for as derivatives, the FASB considered revising the definition of a derivative itself. Under ASC 815, this definition includes (1) having one or more underlyings and one or more notional amounts, (2) requiring little or no initial net investment, and (3) permitting net settlement. The Board ultimately avoided revising the derivative definition, noting that terms within the definition such as “underlying” are already widely used and understood in practice and any changes could create confusion in applying ASC 815 and multiple other codification topics⁶.

Instead, the FASB opted for an additional scope exception to exclude a contract from the scope of ASC 815 when the contract’s underlying is based on the operations of one of the parties to the contract. This includes contingencies tied to the achievement of non-financial metrics, internal milestones, or entity-specific events, rather than market prices or interest rates. Examples of contracts that could qualify for the scope exception include those with terms contingent on:

Receiving regulatory approval for a product,
Prevailing in a legal dispute, or
Achieving predefined Environmental, Social, and Governance (ESG) performance goals.

Initially, the proposed scope exception risked excluding certain contracts that are appropriately within the scope of derivative accounting, such as contracts linked to an entity’s own equity or options embedded in debt instruments. These contracts involve features with market-based risk exposure that align with derivative accounting principles, but because they sometimes become exercisable when an entity-specific event occurs (such as an IPO or change in control), the proposed scope exception could exclude them from ASC 815.

To address this concern, the FASB clarified its position at its April 9, 2025 board meeting. The Board decided to include a specific exclusion to the scope exception, ensuring that contracts involving an entity’s own equity or containing call or put options on debt remain subject to ASC 815⁷.

The FASB also proposed a fair value-based predominant characteristics assessment that would replace the current correlation analysis inASC 815-10-15-60. Entities use this assessment to determine if a contract or feature can qualify for the scope exception in paragraph 815-10-15-59 when the contract or feature has multiple underlyings and only some of them meet the scope exception. Current guidance requires an entity to measure correlation between all of the contract’s underlyings and any underlyings that do not meet the scope exception. If the level of correlation is high, the contract or embedded feature as a whole does not get excluded from ASC 815.

The proposed assessment would require firms to assess which underlying in the contract the firm expects to change the contract’s fair value the most. If this underlying meets the scope exception, the firm does not apply derivative accounting. For example, if an entity has a non-bifurcated contract with both a commodity price and an ESG milestone as underlyings, the firm would need to identify which would be expected to drive the most change in the fair value of the contract.

However, the FASB ultimately decided not to implement the proposed fair value assessment (see the Stakeholder Feedback section below for further details).

What Else Does the Proposed Guidance Cover?

Alongside the changes to derivative scoping, the proposed ASU also clarifies how to account for transactions in which a customer transfers equity shares or instruments to an entity as payment for goods or services. Due to confusion in practice, the FASB is specifying that these payments must first be evaluated under ASC 606 (Revenue from Contracts with Customers). Once the payments are recognized as assets under ASC 606, other topics may apply, such as ASC 815 (Derivatives and Hedging) or ASC 321 (Investments—EquitySecurities).

This clarification aims to promote consistency in practice and further helps preparers determine when a transaction should fall within the scope of derivative accounting.

Stakeholder Feedback

Following the release of the proposed ASU, stakeholders had until October 21, 2024 to submit comments on the FASB’s suggested changes. During that period, 34 individuals, preparers, accounting firms, and industry groups provided input, offering both support and critical feedback regarding scope and application. This section summarizes stakeholder responses to Questions 1 through 3 of the proposal, which focus on the derivatives scope refinements.

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Questions 1-3 for Stakeholders Within FASB’s Proposed ASU

Many respondents, especially accounting firms and preparers, supported the overall direction of the proposed scope exception, especially for contracts tied to entity-specific features, such as ESG-linked instruments and R&D funding arrangements. They agreed that the changes would help reduce accounting complexity, better reflect the economic substance of these contracts, and provide more decision-useful information to financial statement users.

However, several stakeholders raised concerns regarding the operational burden of the proposed predominant characteristics assessment. Those firms highlighted that the fair value-based approach could be costly, particularly for contracts with multiple dependent underlyings. Respondents suggested introducing more practical expedients or qualitative assessments to alleviate the need for costly third-party valuations in some cases.

Respondents also requested clearer implementation guidance, including how broadly to apply key terms such as “one of the parties to the contract.” A few pharmaceutical companies also pushed for clarification of how the scope exception applies to third-party arrangements, such as where one entity (company A) purchases royalty or milestone payment rights from another entity (company B), which licenses its right to development to a third entity (company C).

In response to stakeholder feedback, the FASB decided to drop the new predominant characteristics assessment that would use a fair value assessment and retain current GAAP. They also voted to add language to exclude certain contracts involving an entity’s own equity or call and put options on debt from the scope exception⁸.

Potential Implications and Future Considerations

The proposed adjustment to the scope of ASC 815 is expected to benefit both preparers and investors by excluding certain contracts that the FASB never intended to fall within the derivatives framework. However, this new scope exception also adds to the growing list of carve-outs in ASC 815, requiring an additional layer of analysis for certain contracts and highlighting an ongoing tension between clarity and complexity in derivatives guidance.

The FASB recognizes that scoping and accounting for derivatives can be both costly and complex. Nonetheless, the Board chose not to fundamentally revise the definition of a derivative, citing concerns about disrupting common practice and introducing confusion around well-established terminology. This decision suggests that as new transaction types continue to emerge, the FASB may feel compelled to address issues by layering additional scope exceptions, potentially increasing the volume and intricacy of the guidance under ASC 815. However, the Board’s proposed scope exception generally avoids excluding specific contracts by name and uses general language to increase its applicability.

While the future trajectory of derivatives guidance remains uncertain, the FASB has shown a preference for more principles-based approaches in recent years. This shift is evident in broader standards such as ASC 606, which emphasizes core principles over detailed rules. Similarly, the FASB views the new scope exception in ASC 815 as both broad and principle based. The Board acknowledges that a principles-based exception introduces some level of additional judgment, which may lead to varied interpretations. Even so, such flexibility can enhance the guidance’s relevance across a wider range of transactions and contribute to long-term simplicity.

During the Board’s meeting on April 9, 2025, FASB Chair Rich Jones emphasized the importance of “drawing a line”⁹ in ASC 815 to prevent increasingly broad interpretations from pulling unintended contracts into the derivatives scope. In his view, establishing abroad scope exception helps maintain appropriate boundaries as new transaction types and interpretive challenges arise.

Looking ahead, the FASB appears unlikely to pursue major redefinitions of foundational terms like “derivative” or “underlying.” As a result, ASC 815 may continue to expand through incremental scope exceptions. Despite this, the Board remains committed to issuing guidance that is as broad and principle based as possible, aiming to balance the need for clarity with the desire to avoid frequent standards updates and excessively detailed or burdensome requirements.

Conclusion

Over time, the broad definition of a derivative has led to an increasing number of contracts and features being accounted for as derivatives, even when such treatment leads to unintuitive accounting outcomes and burdensome analysis. The FASB’s proposed scope exception seeks to diminish this issue by excluding from ASC 815 any contracts based on the operations of a party to the contract.

While this change may serve as a targeted solution to current concerns, such as those raised by sustainability-linked bonds, R&D funding arrangements, and litigation funding agreements, it also reflects the FASB’s shift toward principles-based standard-setting. If applied effectively, the new scope exception could help counterbalance the broad definition of a derivative and help ensure that ASC 815 remains appropriately focused as new transactions and interpretations continue to emerge.