Financial instruments

The FASB and IASB have been working on a joint project on financial instruments. The project includes classification and measurement of financial instruments and impairment of financial assets. However, the boards have not converged on each element, so there are expected to be differences in the final standards.

Key Developments Related to Classification and Measurement

  • The FASB completed redeliberations of its May 2010 proposal for classification and measurement of financial instruments. The FASB's May 2010 exposure draft proposed a full fair value model for all financial instruments. On February 14, 2013 the FASB issued its Proposed Accounting Standards Update (ASU), Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which reflects the FASB’s decision to go back to a mixed measurement model that includes measurement at amortized cost for certain financial assets. The exposure draft comment period ended on May 15, 2013.

  • The IASB completed its deliberations on targeted amendments to its classification and measurement standard (IFRS 9) and issued an exposure draft in November 2012. The comment period ended on March 28, 2013.

  • The proposed ASU requires debt investments (loans and debt securities) to be evaluated under a cash flow characteristics test and business model assessment. Instruments passing the cash flow characteristics test will be classified and measured at amortized cost or fair value with changes in fair value recognized in other comprehensive income (OCI), depending on the entity’s primary objective for holding the investment. Fair value with changes in fair value recognized in net income will be the default category.

  • Equity investments (not accounted for under the equity method) will be measured at fair value with changes in fair value recognized in net income. However, entities other than investment companies and broker-dealers will be afforded a practicability exception for investments that do not have readily determinable fair values. Such investments would be measured at cost less impairment adjusted for observable prices.

  • Financial liabilities will generally be recorded at amortized cost with limited exceptions. The fair value option will remain in limited circumstances; if elected, market adjustments related to an entity’s own credit will be recorded in OCI. Separate accounting for embedded derivative features remains, and embedded derivatives will still be measured at fair value with changes in fair value recognized in net income.

  • The FASB’s existing guidance that looks to significant influence in determining whether the equity method of accounting should apply will be retained, except that equity method investments held for sale will be measured at fair value with changes in fair value recognized in net income. A practicability exception would apply for equity method investments that do not have a readily determinable fair value; they would be measured at cost less impairment adjusted for observable prices.

  • The IASB's classification and measurement standard for debt investments is substantially the same as the FASB model. Differences between the IASB standard and the FASB proposal will remain, specifically in the accounting for equity investments.

  • Comment letters summarized by the FASB indicate that a majority of respondents support the goal of reducing complexity in financial instruments accounting but many believe it would not be achieved under the proposal. Many felt that the cash flow characteristics test would inappropriately limit the number of debt investments that would be eligible for amortized cost or fair value through other comprehensive income measurements. While respondents tended to agree with a business model assessment, a majority felt that the restrictions on sales out of the amortized cost category would inappropriately limit companies' ability to manage their credit risk exposures.

  • The IASB's proposal, comprising limited amendments to its classification and measurement standard, generally received support. A majority of respondents supported adding a fair value through other comprehensive income category to the amortized cost and fair value through net income categories for debt investments.

  • The boards discussed the responses in May and June and joint redeliberations began in September.

  • Up until late December, the boards had been jointly redeliberating their original proposals. However, when the boards reconvened in late December, the IASB affirmed its plans to move forward with the existing proposals, while the FASB decided to abandon the cash flow characteristics test for determining the classification of a financial instrument in its entirety. Instead, the FASB reverted to a bifurcation model based on the nature of the components of a hybrid financial instrument.

  • The FASB’s recent decision on debt investments represents a major change from its proposed model and is a significant setback to achieving global convergence in the classification and measurement of financial instruments. Prior to this decision, the FASB and IASB’s proposals for debt investments had been substantially converged.

Key Developments Related to Impairment

  • In 2012, the FASB and IASB moved in different directions in their approaches to developing a new impairment model for financial assets. The IASB's approach would classify debt investments into categories that reflect the pattern of credit deterioration over time. The categories would determine the amount and timing of when credit losses would be recognized in earnings. Assets would initially be recognized in category one, where a credit loss would be recorded based on the probability of a default in the next twelve months. Assets would move to category two when there has been a significant deterioration in credit risk. At that point an allowance would be recorded to reflect a lifetime of expected credit losses. The IASB issued an exposure draft on its impairment model, referred to as the “credit deterioration model,” in March, 2013.

  • The FASB believes that aspects of the IASB's model are difficult to operationalize and would result in a credit allowance that does not fully represent all expected losses on an asset. Prior to experiencing a significant deterioration in credit, the IASB model would only record 12 months of expected losses. Thus, the FASB opted to establish a model that it views as more operational and would result in the full expectation of credit losses being reported on the balance sheet. The FASB's model, referred to as the current expected credit loss (CECL) model, requires an allowance to be recorded to reflect the amount of contractual cash flows not expected to be collected. The FASB issued an exposure draft on the CECL model in the fourth quarter of 2012.

  • The comment period for the FASB’s exposure draft ended on May 31, 2013, and the comment period for the IASB’s exposure draft ended on July 5, 2013. Generally, respondents to the IASB model supported the proposed model, but suggested various refinements. The IASB is currently working to address these concerns. With respect to the FASB model, feedback was mixed. Users generally supported the FASB model, as they preferred a model that would require recognition of all credit losses (as opposed to only ‘some’ expected credit losses). Preparers, on the other hand, did not support the FASB’s proposed model. Preparers believed that recognition of a full lifetime of expected credit losses on day 1 would not reflect the economics of lending transactions. Instead, preparers preferred a model that would recognize those losses expected to occur in the ‘foreseeable future’ or some other truncated period.

  • Throughout the fall of 2013, the FASB conducted outreach with both preparers and users. Based on feedback received during this outreach as well as the comment letters, the FASB considered various options in terms of a path forward on impairment. On December 18, 2013, the FASB discussed the four main alternatives and voted on a path forward. The alternatives discussed by the FASB were (1) a “gross up” approach, whereby the initial estimate of expected credit losses would be recorded in OCI, (2) a “truncated” approach, whereby losses would be estimated over a shorter period than the proposed lifetime loss model, (3) a deterioration model similar to the IASB’s impairment proposal, and (4) move forward with the CECL model with refinements made where necessary. In weighing the costs and benefits associated with each alternative, as well as user needs, the FASB voted to move forward with the CECL model and refine various aspects, where necessary. It is not clear exactly what refinements will be made at this time.

What's next

  • Classification and measurement: The FASB will continue redeliberations on this project through the first half of 2014. However, it remains to be seen whether any aspects of the boards’ redeliberations will continue to be conducted jointly with the IASB.

  • Impairment: A final standard is expected in the second quarter of 2014.

 

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