Accounting for Indexed Powered^SM CDs Under Statement 133

The Index Powered^SM CD (IPCD) is a new FDIC insured certificate of deposit with interest tied to the Standard & Poor's 500 Index (S&P 500®). It is used by community banks, both as a deposit alternative and as a bank investment. Although use of the instrument is growing¹, some banks may not be aware of the complex accounting implications that such use raises under Statement of Financial Accounting Standards No. 133, Accounting for Derivatives and Hedging Activities (Statement 133). IPCDs have embedded derivatives that must be accounted for separately.

This memo provides an overview of the IPCD and the accounting².

IPCDs and the Federal Home Loan Bank Program

An IPCD has a five-year maturity, is insured up to $100,000 by the FDIC and has a variable interest rate tied to the performance of the S&P 500 Index. If the average S&P 500 Index (based on 12 quarterly assessments over 5 years) has increased, the IPCD holder will receive, as interest, 90% of the percentage gain. If the average index is lower, only the holder's principal will be returned. Payments are made only at maturity with penalties for early withdrawal.

Although big banks and brokerages have offered equity-based CDs for many years, such instruments were often out of reach for community banks unable to hedge the corresponding interest rate exposure. To help banks manage this risk, the Federal Home Loan Banks (FHLB) offer an interest rate contract that swaps the variable interest on the IPCD with either a fixed or variable interest payment. In each district, community banks must sell an aggregate of at least $5 million to qualify for the interest rate swap. The more IPCDs the community banks generate each month, the better the funding price for all banks that participate in the program.

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Statement 133

Statement 133 applies to all entities and sweeps in a broad range of transactions. It defines a derivative as any contract with all three of the following characteristics: (1) an underlying, and either a notional amount or payment provision; (2) no initial investment, or an initial investment that is not significant; and (3) net settlement by its terms, by means outside the contract or by the underlying asset being readily convertible to cash³.

Statement 133 requires every derivative (with certain exceptions) to be recorded in the balance sheet as an asset or liability at its fair value. In addition, certain "hybrid" contracts that, in their entirety, do not meet the definition of a derivative instrument may contain "embedded" derivative features that change some or all of the future cash flows based on one or more underlyings. The Financial Accounting Standards Board concluded that an entity should not be allowed to avoid the recognition and measurement requirements of Statement 133 merely by embedding a derivative instrument in a nonderivative instrument or other contract. Thus, embedded derivative instruments must be separated from the host contract and accounted for as derivatives whenever they are not clearly and closely related to the economic characteristics and risks of the host contract. Separate accounting is not required if the entire contract is marked to fair value or a separate instrument with the same terms as the embedded derivative instrument would not be considered a derivative for purposes of Statement 133. Equity-indexed interest payments are an example of embedded derivatives that must be separated from the host contract under Statement 133.

The link between the interest earned on the IPCD and the investment return on the S&P 500 is considered an "equity call option" which meets the definition of a derivative under Statement 133. Because the changes in fair value of an equity interest (whether based on the price of a specific common stock or on an index that is based on a basket of equity instruments) and the interest yield on a debt instrument are not considered clearly and closely related, the embedded equity call option must be accounted for separately from the host contract (i.e., the CD).

IPCD as an Investment - Sample Journal Entries
IPCD as a Deposit - Sample Journal Entries

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