On February 14, the FASB issued a revised proposal for the classification and measurement of financial instruments1. Classification and measurement is one part of the FASB and IASB’s broader financial instruments project. The other parts consist of impairment and hedge accounting2. The IASB previously finalized its classification and measurement approach, but in late 2012, proposed targeted amendments to its guidance3.
The FASB’s proposal calls for a mixed measurement approach for financial assets and financial liabilities — either fair value or amortized cost. It is intended to be responsive to the considerable feedback the FASB received on its 2010 exposure draft, which proposed fair value measurement for all financial instruments.
A copy of the FASB's exposure draft is available on its website at www.fasb.org.
The FASB’s proposal will apply to financial instruments as defined in the master glossary, with certain exceptions, and address both initial and subsequent classification and measurement. Some of the key elements of the approach are summarized below4.
Debt investments (loans and debt securities) will be classified into one of three measurement categories: amortized cost, fair value with changes in fair value recognized in other comprehensive income, or fair value with changes in fair value recognized in net income. The classification and measurement of a debt investment is determined when it is first acquired or originated based on the business model and the cash flow characteristics, as follows:
In addition, hybrid financial assets will not be bifurcated between embedded derivatives and the financial instrument host contract as is done today. Instead, the entire instrument will be evaluated and classified based on the above criteria.
For debt investments that qualify for measurement at fair value through other comprehensive income, companies will have an unrestricted option to classify the investments at fair value through net income.
Equity investments not subject to the equity method of accounting will be measured at fair value through net income. However, companies (excluding broker-dealers and investment companies) can elect a practicability exception to measure equity investments without a readily determinable fair value at cost, adjusted for both impairment and observable price changes for orderly transactions in the same or similar instrument of the issuer. The proposal also simplifies the method for assessing impairment for equity investments that qualify for the practicability exception, as well as equity investments accounted for under the equity method.
In addition, application of the equity method of accounting will be prohibited if an investment is held for sale. Instead, the investment will be measured at fair value through net income.
Financial liabilities will generally be measured at amortized cost, and the current embedded derivative bifurcation requirements for hybrid financial liabilities will be retained. If financial liabilities are held with a business strategy to subsequently transact at fair value or are short sales, they will be measured at fair value through net income. Nonrecourse financial liabilities that must be settled with only the cash flows from specified financial assets will be measured on the same basis as the financial assets.
A fair value option is available in certain limited circumstances. If a company elects the fair value option for a financial liability, it will recognize the change in fair value due to a change in the company's own credit risk in other comprehensive income.
Presentation and disclosure
Public companies will present fair values parenthetically on the face of the balance sheet for financial assets and financial liabilities measured at amortized cost. Only demand deposit liabilities and receivables and payables that are due within one year are excluded from this requirement. Nonpublic companies will not be required to present or disclose fair value information for these instruments.
While the FASB's and IASB's respective proposals include a substantially converged approach for debt investments, other differences will remain, such as the accounting for equity investments. In addition, there are wording differences in the guidance for debt investments that may give rise to differences in application and interpretation if they remain in the final standards.
While certain financial institutions such as retail and commercial banks and insurance companies are likely to be most affected by this proposal, other companies with large investment portfolios that are not currently measured at fair value through net income may also be significantly impacted.
The FASB will decide on an effective date once it has received feedback on the time needed to implement the proposed changes.
Comments on the FASB's proposal are due May 15, 2013.
PwC clients who have questions about this In brief should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).
1 Proposed Accounting Standards Update, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities
2 The FASB issued an exposure draft on impairment in December 2012. Hedge accounting is not currently being discussed by the FASB.
3 Refer to In brief 2012-55, IASB proposes limited amendments to its financial instruments guidance under IFRS 9.
4 For additional details on the proposed model, refer to Dataline 2012-21, Financial instruments classification and measurement.
5 For additional details, refer to Appendix I of Dataline 2012-21, Financial instruments classification and measurement.
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