FASB and IASB trade proposals
The Financial Accounting Standards Board (FASB) on May 26 issued an exposure draft (ED) on Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. This guidance will replace many areas commonly referenced when dealing with financial instruments and hedging found in FAS 133, and guidance on impairment of debt instruments found in other related standards. The ED focuses on three key provisions: hedge accounting, classification and measurement of financial instruments, and impairment and interest recognition.
Classification and measurement
There are significant changes proposed in the way financial instruments are reported in the financial statements. Financial instruments carried at amortized costs will continued to be reported in the same manner but the FASB also proposed that companies show a fair value reconciliation in a new Fair Value-OCI category created in the income statement.
The net income calculation will stay the same. In addition, the EPS computation will still be based on the current components. However, a new statement is being proposed to report total comprehensive income. Fair value-OCI items will now be presented separately, and subtotals are required for net income and OCI to derive the total comprehensive amount. OCI will be used to report changes in fair value, or current period interest accruals, and the current portion of changes in fair value attributable to credit losses. It will also be used to capture other allowable changes, such as cumulative translation adjustments.
The guidance for assessing credit impairment is found in many documents, and there are many different models for doing so depending upon the type of instrument and its applicable standard. FASB has now attempted to require only one model for assessing credit impairment for all financial instruments. Credit impairment will be recognized in net income at the end of the reporting period when a company does not expect to collect either all amounts contractually due for originated financial assets or all amounts originally expected for purchased financial assets. When assessing impairment, a company is allowed to consider past events and existing conditions, but the FASB stopped short of adopting an expected loss model and allow possible future events to be taken into account. Evaluating credit impairment collectively, or on a pool basis, is still permitted in limited circumstances.
This ED attempts to simplify the onerous reporting requirements currently found in the accounting guidance. One way it attempts to simplify hedge accounting is by relaxing the effectiveness thresholds for obtaining hedge accounting. To qualify the hedge, both fair value and cash flow hedges must prove to be "highly effective" (80 to 120 percent). The proposed guidance has lessened this threshold to "reasonably effective". However, the FASB was silent on defining any thresholds for what it considers to be reasonably effective.
In addition, the FASB relaxed its rules regarding subsequent assessments of hedge effectiveness. The current guidance requires that at each reporting period companies perform an assessment of the effectiveness of the hedge. The proposed guidance still requires an initial qualitative assessment, but would only require a reassessment if circumstances change that may impact the initial assessment.
One of the biggest changes that will have an impact on AFP members is the elimination of the shortcut method as well as the critical terms match method for qualifying for hedge accounting, and thus reporting less volatility in earnings. FASB's rationale was that, now that the rules for qualifying and measuring are less stringent, this shortcut no longer is needed. Additionally, bifurcation by risk will now be allowed for financial items.
Another significant change is that a company will no longer be allowed to de-designate a hedge at its convenience. De-designation would only occur if the item being hedged no longer qualified for hedge accounting, or the instrument expired, was sold or terminated. Fair value hedge changes attributed to the hedge risk will now be recognized in net income not OCI and embedded derivatives in hybrid financial instruments no longer have to be bifurcated and accounted for separately. The entire instrument will be measured at fair value.
The International Accounting Standards Board (IASB) is taking a different approach to revising its parallel guidance. The IASB has begun to issue its revisions to fair value instruments (IAS 39) in three phases. Phase I was released on Nov. 12, 2009, with the publication of International Financial Reporting Standards 9 (IFRS 9) Financial Instruments, which covers the classification and measurement of financial assets. To finish up this area, the IASB will publish a separate document on the classification and measurement of financial liabilities. In May 2010, the IASB also published as part of phase I the ED, Fair Value Option for Financial Liabilities.
Phase II focuses on credit impairment. The ED, Amortised Cost and Impairment, was published in November 2009. Finally, the IASB is completing Phase III of this project. The IASB is in the process of fundamentally reconsidering its current hedge accounting requirements for both financial and non-financial hedged items.
FASB chose to issue one comprehensive statement while the IASB is doing its revision in phases. FASB explains its decision not to follow the IASB's phase-in approach as a result of the two groups' different timetables for issuing guidance. Thus, differences still exist between the two boards in their proposed standards in spite of the convergence goal.
For example, under IFRS, companies can make an irrevocable election for the fair-value option at initial recognition for financial assets if measuring at fair value eliminates or significantly reduces a measurement or recognition inconstancy (accounting mismatch). For financial liabilities, the irrevocable option would be available at initial recognition if measuring at fair value eliminates or significantly reduces accounting mismatch; a group of financial instruments is managed and its performance is evaluated on a fair value basis; or the liability contains one or more separable embedded derivatives and the entity elects to account for the hybrid contract in its entirety. However, the fair value option is not applicable for financial instruments in the FASB's proposed guidance.
Another example is for impairment. The IASB proposes entities follow an expected loss model that would require them to determine the expected credit losses on a financial asset when that asset is first recognized. Initial expectations for credit losses would be included in determining the effective interest rate. An expected loss model would recognize loss estimates throughout the life of a loan (or portfolios of loans) and other financial assets recorded at amortized cost. Expected credit losses would be reassessed each period and the effects of any changes in expectations would be recognized in net income immediately.
The FASB's model is still based on an incurred loss model. Under an incurred loss model, impairments are recognized only after a loss or trigger event is identified. In determining whether credit impairment exists, an entity would consider all available information relating to past events and existing economic conditions and their implications for the collectability of the financial assets.
Finally, a company's Statement of Financial Position (Income Statement) will change significantly under FASB's proposal as earlier discussed, whereas there are no significant changes proposed under the IASB's revisions.
While the goal of the two boards was to improve their two financial instrument standards and converge concepts, it appears they got the memo on the former but not the latter. Perhaps their goal in taking different paths is to expose various conceptual frameworks to the public in order to select the best one based on constituent feedback. Perhaps there still is a turf battle in which both groups are trying to flex their muscles. Whatever the case may be, multinational companies are still faced with two different standards for reporting their financial instruments.
The question is whether the boards will swallow their pride and come to a compromise. If only the two boards would see that the best solution is the best of the ideas from each proposal.