FASB/IASB joint project: Financial instruments
In May 2010, the FASB issued a comprehensive exposure draft to change existing guidance on financial instruments. The decision was subsequently made to divide the project into three parts: (1) classification and measurement, (2) impairment and (3) hedging. Following is a discussion of each component that summarizes the FASB’s activities through April 27, 2016, as well as the status of international convergence on the accounting for financial instruments.
Classification and measurement
On January 5, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, its long-awaited final standard on the recognition and measurement of financial instruments. The ASU applies to all entities that hold financial assets or owe financial liabilities and is effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. For those entities that are not public business entities, the ASU is effective for fiscal years beginning after December 15, 2018, and for interim periods within fiscal years beginning after December 15, 2019. Certain provisions may be early adopted.
The most far-reaching ramification of the ASU is the elimination of the available-for-sale classification for equity securities and a new requirement to carry those equity securities with readily determinable fair values at fair value through net income. Other notable changes brought about by the ASU involve: (a) applying a practicability exception from fair value accounting to equity securities that do not have a readily determinable fair value, (b) assessing the need for a valuation allowance for a deferred tax asset related to an available-for-sale debt security, (c) applying the fair value option to liabilities and the treatment of changes in fair value attributable to instrument-specific credit risk and (d) adding disclosures and eliminating certain disclosures.
Our white paper, Financial instruments: FASB issues standard on recognition and measurement, provides in-depth analysis of the changes made by the ASU to existing U.S. generally accepted accounting principles (GAAP). In addition, our white paper outlines the ASU’s effective date and transition provisions and discusses how to plan ahead for implementation. It concludes with a discussion on convergence and a chart that provides a comparison of current U.S. GAAP to the ASU and International Financial Reporting Standard (IFRS) 9, Financial Instruments (July 2014).
In December 2012, the FASB issued a proposed ASU, Financial Instruments—Credit Losses (Subtopic 825-15) (the 2012 proposed ASU), which included a new accounting model intended to require more timely recognition of expected credit losses on financial assets that are not accounted for at fair value through net income. The 2012 proposed ASU would have applied to all entities that hold financial assets exposed to credit risk, including debt instruments, as well as loan, lease, reinsurance and trade receivables.
During redeliberations that have occurred subsequent to the 2012 proposed ASU, the FASB reaffirmed its decision to move to a current expected credit loss (CECL) model, but decided that the model would only apply to financial assets that are measured at amortized cost. Existing guidance in ASC 320, "Investments—Debt and Equity Securities," for recognition of other than temporary impairment would continue to apply to AFS debt securities with some modification, the most significant of which is that impairment would be recognized through an allowance approach rather than direct write-down so that credit losses could be reversed immediately through expense as circumstances warrant rather than accreting improvements in expected cash flows into interest income over the remaining life of the securities. Additionally, decisions have been made to exclude certain other financial assets from the scope of the CECL model, namely, loans made to participants by defined contribution employee benefit plans, policy loan receivables of an insurance entity, pledge receivables of a not-for-profit entity and related party loans and receivables between entities under common control.
Rather than recognizing losses as they are incurred (which is the case under existing guidance), the CECL model would entail day-one recognition of life-of-asset expected losses. Highlights of applying the CECL model based on decisions made to date are as follows:
- Financial assets would be evaluated on a pool basis when similar risk characteristics exist. Otherwise, they would be evaluated individually with consideration given to relevant external information such as credit losses of assets with similar credit quality.
- When estimating expected credit losses, consideration would be given to the following: (a) past events, current conditions and reasonable and supportable forecasts, (b) qualitative and quantitative factors related to both the environment the entity operates in as well as factors specific to the borrower, considering both internal and external sources of information and (c) life-time contractual cash flows considering expected prepayments, but not extensions, renewals or modifications unless the entity reasonably expects to execute a troubled debt restructuring with the borrower.
- An entity would revert to unadjusted historical credit loss experience for the future periods beyond which the entity is able to make or obtain reasonable and supportable forecasts.
- Estimates would always reflect even remote risks of loss; however, loss recognition would not be required on a financial asset if the amount of loss would be zero. This is to clarify a concept contained in the 2012 proposed ASU, namely that an estimate always needs to reflect the possibility that a loss exists rather than use the most likely outcome. To illustrate the clarified concept, there is a risk of default, however remote, associated with United States Treasury securities; however, management may estimate that no losses would be incurred upon default given the full guarantee of a strong sovereign entity that can print its own currency.
- Examples of methods used to estimate expected credit losses could include discounted cash flow models as well as loss-rate methods, probability-of-default methods or a provision matrix using loss factors.
- The allowance for collateral-dependent financial assets and those assets for which the borrower must continually adjust the amount of underlying collateral would be established based on the difference between the collateral’s fair value (adjusted for selling costs, when applicable) and the amortized cost basis of the asset.
- An acquisition date allowance would be established through a gross up of the asset’s purchase price (rather than through recognition of provision expense) for a purchased credit impaired (PCI) asset; however, subsequent changes in expected credit losses (whether favorable or unfavorable) would be recognized through the provision for credit losses. PCI assets would be defined as purchased assets with more than insignificant credit deterioration since origination.
- The allowance for expected credit losses on purchased or retained beneficial interests for which there is a significant difference between contractual and expected cash flows would be measured and recognized consistent with the above discussion for PCI assets. However, non-credit related changes in expected cash flows would be accreted into interest income over the life of the asset rather than recognized through the provision for credit losses.
In addition, the FASB has decided to expand disclosure requirements as follows:
- A period-to-period rollforward of the allowance for expected credit losses would be required for those assets (debt securities) measured at fair value through other comprehensive income as well as those financial assets measured at amortized cost.
- Disclosures of credit quality indicators would be disaggregated by year of the asset’s origination (i.e., vintage year) for all classes of financing receivables except reinsurance receivables and revolving lines of credit (e.g., credit cards) for up to five annual reporting periods, with the balance for financing receivables originated before the fifth annual reporting period shown in the aggregate. Disaggregation by year of origination would only be required of public business entities. Additionally, public business entities that are not SEC filers will only be required to show three years of disaggregated information in the year of adoption, followed by four years of information in the year subsequent to adoption and the full five years of information thereafter.
- The method applied to revert to historical credit loss experience for periods beyond which reasonable and supportable forecasts could be prepared or obtained.
Transition to the new requirements would be through a cumulative effect adjustment to the statement of financial position as of the beginning of the first reporting period in which the guidance is adopted, except for the following:
- The proposed new requirements for other than temporarily impaired debt securities would be applied prospectively. Amounts previously recognized in accumulated other comprehensive income as of the date of adoption that relate to significant improvements in cash flows would continue to be accreted to interest income over the remaining life of the debt security on a level-yield basis. Any improvements in cash flows of a security due to improvements in credit after the date of adoption would be recorded as a reduction in the allowance for credit losses.
- Those assets accounted for under ASC 310-30, “Receivables – Loans and Debt Securities Acquired with Deteriorated Credit Quality,” would be classified as PCI assets at the date of adoption (including those acquired assets for which ASC 310-30 has been applied by analogy). Entities would be required to gross up the allowance for expected credit losses for all PCI assets at the date of adoption and would continue to recognize interest income based on the yield of such assets as of the adoption date. Subsequent changes in the expected credit losses on such assets would be recorded through the allowance for credit losses, with a corresponding adjustment to the current period provision for credit losses. These transition provisions would also be applied to certain beneficial interests.
The final standard is expected to come into effect as follows:
- SEC filers: Fiscal years beginning after December 15, 2018 (including interim periods within those years)
- Public business entities other than SEC filers: Fiscal years beginning after December 15, 2019 (including interim periods within those years)
- All other entities: Fiscal years beginning after December 15, 2019 (and interim periods thereafter)
Entities will be permitted to early adopt the final standard in its totality for fiscal years beginning after December 15, 2018.
The final standard is expected to be issued in June.
At the November 5, 2014 FASB meeting, the decision was made to add the hedging project to the technical agenda, with a goal of simplifying the application of hedge accounting and providing better linkage to entities risk management programs. The following tentative decisions have been made thus far:
- The highly effective threshold requirement inherent in current guidance will be retained for all hedging relationships.
- The initial requirement to quantitatively test the effectiveness of hedges will be retained (unless the hedges meet the requirements for the shortcut or critical terms match methods). While the required timing for the preparation of hedge elections will not change, entities could take as long as the first three-month effectiveness testing period to perform the initial quantitative testing.
- Subsequent quantitative effectiveness testing will be required only if facts and circumstances change.
- In those circumstances where the shortcut method was applied and was or is no longer appropriate, an entity could apply a long-haul method and continue to apply hedge accounting uninterrupted if the hedge remained highly effective from its inception. Initial hedge documentation will require selection of the long-haul methodology that will be applied in this circumstance. (Under current guidance, if the determination is made that the shortcut method was inappropriately applied, the hedge election would be deemed invalid from inception and efforts to qualify for hedge accounting prospectively would be complicated by the derivative no longer being at market.)
- For those hedges that are highly effective, ineffectiveness would no longer be separately recognized. The entire change in the fair value of the derivative would be recorded in the same income statement line item as the item being hedged for fair value hedges and in other comprehensive income for cash flow hedges (cumulative translation adjustment section of other comprehensive income for net investment hedges). Amounts in other comprehensive income would be reclassified to the income statement line item being hedged when the hedged item affects earnings).
- Any portions of a hedging instrument’s change in fair value that are excluded from the assessment of hedge effectiveness would continue to be recognized immediately in earnings.
- Component hedging would be permitted for nonfinancial items. Hedged items could be a contractually specified component or an ingredient that is linked to an index or rate stated in the contract, including those that have caps, floors or negative basis associated with the contractual pricing if the effectiveness criteria are met. (Under current guidance, hedge accounting is difficult to achieve for many commodities and other nonfinancial items given that only total changes in cash flows or fair value can be hedged and most derivatives only address the risk of a component of the total exposure.)
- The concept of benchmark interest rates would be eliminated for variable-rate financial instruments as an entity could designate the contractually specified index rate in cash flow hedges of interest rate risk as the hedged item. The existing definition of benchmark interest rates would be expanded for hedges of fixed-rate financial instruments to include the Securities Industry and Financial Markets Association Municipal Swap Index (SIFMA).
- Other decisions related to fair value hedges of financial instruments include:
- In a hedge of interest rate risk, an entity could designate the benchmark component of the total coupon cash flows as the hedged risk rather than all contractual cash flows (which necessitates considering credit spreads). If the effective interest rate of the financial instrument is less than the benchmark interest rate on the date of hedge designation, the entity would be required to use the total coupon cash flows.
- For callable debt, an entity could limit its consideration of the effect of a prepayment option to the risk designated as being hedged (for example, interest rate risk).
- A portion of the term of a financial instrument could be designated as the hedged risk rather than the entire term. An entity would be permitted to calculate the change in the fair value of the hedged item by assuming the same term as the derivative designated as the hedging instrument.
- Current guidance that permits voluntarily de-designating hedges would be retained.
- Existing disclosure requirements would be expanded and modified.
A draft of the proposed ASU is expected to be released for comment during the third quarter of 2016. Refer to the related FASB project update page for more information.
On July 24, 2014, the IASB completed its project on financial instruments by issuing amendments to IFRS 9. As amended, IFRS 9 will be effective for annual periods beginning on or after January 1, 2018, with early application permitted. Based on the decisions that the FASB has made thus far, convergence will not be achieved despite the fact that financial instruments began as a joint project of the two boards. Divergence may in fact be greater than when the joint project began. Some of the more notable differences relate to the following aspects of IFRS 9:
Classification and measurement
- An entity can elect to account for certain equity investments at fair value through other comprehensive income (FV-OCI) rather than account for them at fair value through net income (FV-NI).
- Classification of other financial assets is based on the contractual cash flows characteristics of the instrument and the business model in which the assets are managed. Depending on the facts and circumstances, the accounting outcome could be FV-NI, FV-OCI or amortized cost for both loans and debt securities.
- Financial assets are no longer subject to the derivative bifurcation requirements.
- The fair value option is more restrictive compared to ASC 825 in U.S. GAAP.
- The new model applies to FV-OCI assets in addition to those carried at amortized cost.
- The allowance is limited to 12-month expected credit losses until credit risk increases significantly.
- The allowance for PCI assets is based on the change in lifetime expected credit losses since acquisition.