Financial instruments – Classification and measurement

Date recorded:

Education session on FASB model

The FASB staff provided the IASB with an update on the FASB's decisions to date on its re-deliberations of their financial instrument classification and measurement project. The FASB has reversed its proposals in the exposure draft where the default classification for financial instruments would be fair value through net income. The FASB has now introduced three primary measurement categories: fair value through net income (FV-NI), fair value through other comprehensive income (FV-OCI) and amortised cost. The classification within each of those categories will be driven by both the characteristics of the instrument and an entity's business strategy, but reclassifications between categories for changes in business strategy would not be permitted. Hybrid financial instruments (both assets and liabilities) would continue to be analysed for potential bifurcation. For items measured at FV-OCI, the amounts recognised in OCI would be recycled upon ultimate disposal or derecognition of the investment.

The initial measurement for items measured at FV-NI is fair value while items measured at FV-OCI and amortised cost would be measured at the transaction price. However, investment companies would be permitted to retain their current practice of initially measuring items at the transaction price (and then subsequently marked to fair value at the following reporting date).

The characteristics of the instrument criteria would permit a debt instrument to be carried at other than FV-NI so long as: it is not a financial derivative, an amount is transferred to the debtor at inception (or acquisition) that will be returned to the creditor at maturity or other settlement which is the principal amount of the contract adjusted by any discount or premium at acquisition, and it cannot contractually be prepaid or otherwise settled in such a way that the creditor would not recover substantially all of its initial investment. Under the charactheristics of the instrument criteria, derivatives and equity investments would be measured at FV-NI while debt securities, loans and trade receivables would typically be eligible for either FV-OCI or amortised cost measurement. However, the FASB has decided to permit an exception for non-public entities holding nonmarketable equity investments such that those investments would be held at cost subject to impairment and adjustment for observable price changes.

The business strategy criterion is based on each of the three measurement categories. For amortised cost measurement, the business strategy must be to manage through customer financing or lending activities with a primary focus on collection of substantially all contractual cash flows, the holder must have the ability to manage credit risk by negotiating any potential adjustment of contractual cash flows in the event of a potential credit loss, and not holding the investment for sale. For FV-OCI measurement, the business strategy must be investing either to maximise total return by collecting contractual cash flows or selling or manage interest rate or liquidity risk by holding or selling as well as not holding the investment for sale. And finally, for FV-NI measurement, the business strategy would be either holding the investment for sale or actively managing the investment on a fair value basis but that does not qualify for FV-OCI category.

For financial liabilities, the default classification category would be amortised cost. However, derivatives, short sales and liabilities held for transfer at inception when the holder has the ability and means to transact at fair value would each be recognised at FV-NI. Additionally, financial liabilities where financial assets are used to settle the liabilities would follow the accounting for the assets (i.e., debt securities in a consolidated securitisation trust would follow the accounting for the assets of the securitisation trust).

The FASB does not plan to permit a fair value option for financial assets, but does plan to permit a conditional fair value option for hybrid financial liabilities if an embedded derivative would otherwise require bifurcation.

The topics still remaining for discussion include recognition and calculation of fair value changes related to own credit, presentation, disclosures, loan commitments, instrument that can only be redeemed for a certain amount, scope and effective date and transition.

The IASB members asked the FASB staff and Board members various questions on the FASB's decisions on financial instrument classification and measurement. One IASB member asked if a financial institution was managing interest rate risk by matching locking in a margin between their deposit liabilities and their lending assets, would those lending assets qualify for amortised cost or FV-OCI classification. Some of the FASB members had differing views based on application of the business strategy criteria. The FASB chair acknowledged they would need to clarify how the business strategy criteria would be applied. Another IASB member noted that during the IFRS 9 project he originally supported an approach similar to that under development by the FASB. He noted that the model was included as an alternative view in the IFRS 9 exposure draft but received very little support and wondered if the FASB had any thoughts on the feedback the IASB had received. One of the FASB members noted that the Boards have received views from US constituents that are not consistent with views of constituents in other jurisdictions, therefore it is not overly surprising to hear IASB constituents may not have supported such an approach.

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