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Journal Entry — Financial Instruments — FASB Staff Summarizes Comments on Classification and Measurement

Published on: Jun 20, 2013

At the FASB’s and IASB’s joint meeting this week, the FASB staff summarized the feedback from comment letters and outreach on the FASB’s proposed Accounting Standards Update (ASU) Recognition and Measurement of Financial Assets and Financial Liabilities and related consequential amendments.1 The key themes of the feedback are highlighted below.2 General observations included the following:

  • Many respondents supported the proposed ASU’s stated objectives, which are to (1) reduce the complexity,
    (2) improve the quality and quantity of decision-useful information, and (3) converge U.S. GAAP and IFRS guidance on the accounting for financial instruments.
  • Many preparers supported the introduction of a business model assessment for classifying financial assets. However, many would also prefer that this assessment be the primary or sole basis for classification. Further, many suggested eliminating the proposed contractual cash flow characteristics assessment.
  • Unlike preparers, users strongly supported the dual-assessment model (i.e., the requirement to classify financial assets on the basis of an instrument’s contractual cash flow characteristics and the business model in which it is managed, along with similar assets).

Contractual Cash Flow Characteristics

As noted above, many preparers recommended eliminating the proposed contractual cash flow characteristics assessment. Generally, these preparers recommended retaining the existing guidance in U.S. GAAP under which an entity determines whether a hybrid financial asset contains an embedded derivative that must be bifurcated and accounted for separately at fair value. These respondents observed that current U.S. GAAP is well understood, even if complex, and that a lack of sufficient implementation guidance on the contractual cash flow characteristics assessment could lead to diversity in practice and greater complexity.

Many preparers also expressed the concern that the contractual cash flow characteristics assessment could force entities to use fair value accounting for hybrid financial assets with immaterial features that fail the cash flow characteristics assessment. Preparers also noted that restatement may be required when an entity overlooks an immaterial feature that fails the assessment. That is, entities may need to restate prior-period financial statements to account for the asset as if it were initially classified at fair value with all changes recognized in net income (FV-NI).

Many respondents were also concerned about the application guidance on beneficial interests in securitized financial assets. They expressed general disagreement with the FASB’s proposed “look-through” guidance on the basis that it would be difficult to apply in practice. For example, they believed that it would be complex and difficult to look through multiple resecuritization vehicles to identify the assets that ultimately give rise to the beneficial interests’ cash flows and to gather sufficient information about those assets, including their purchase price.

Respondents also suggested that if the FASB retains the contractual cash flow characteristics assessment, it should make improvements to it, including:

  • Changing “solely payments of principal and interest” to “primarily (or substantially) payments of principal and interest.”
  • Modifying the definition of “principal” to emphasize the amount lent or borrowed; although, some recommend not providing a definition since the term is well understood in practice.
  • Modifying the definition of “interest” to include not only time value of money, compensation for credit risk, and liquidity premiums but also profit margin, funding costs, and servicing costs.
  • Defining time value of money.
  • Ensuring that features unrelated to credit risk, leverage, or interest rate resets that are “(a) likely to have only a small effect on cash flows or (b) that are unlikely to arise in the future” do not drive the classification outcome.
  • Providing application guidance on the treatment of specific instruments, including:
    • Credit cards with below-market introductory rates.
    • Loans indexed to a bank’s prime rate.
    • Auction rate securities.
    • Debt-like equity instruments.
    • Loan participations.
    • Revenue bonds.
    • Adjustable rate mortgages.

Business Model Assessment

Respondents were generally supportive of the FASB’s proposal requiring entities to assess the business model in which they manage financial assets as part of a model to classify financial assets. In fact, many respondents advocated using the business model assessment as the primary or sole basis for classifying financial assets. However, respondents also expressed concerns that:

  • The application guidance in the FASB’s proposed ASU related to the business model assessment differs from the guidance in IFRS 93 and the IASB’s proposed amendments in ED/2012/4,4 which could lead to diversity in practice (although the principles appear to be converged).
  • The FASB’s application guidance related to sales out of an amortized cost business model may be too restrictive — some prefer the related application guidance in IFRS 9 that permits infrequent sales if the volume is not significant or permits sales of greater volume if they occur infrequently.
  • The business model objective for the fair value through other comprehensive income (FV-OCI) category is not clear; for example, some noted that the level of sales that would be permissible was unclear.
  • There may not be a conceptual basis for the recognition of gains and losses in other comprehensive income (although support was generally expressed for the FV-OCI category).

Some respondents also requested clarification about whether the business model should be assessed at the portfolio or business unit level or at the entity level and about the interaction between such assessment and the entity-level conditions requiring reclassifications of financial assets when there is a change in business model.

Other Comments

Respondents strongly agreed with the FASB’s proposed requirement that entities account for financial liabilities at amortized cost, with certain exceptions. However, many nonusers advocated retaining the unconditional fair value option currently in U.S. GAAP, which would enable preparers to account for financial liabilities (and financial assets) at FV-NI with limited restrictions.

A majority of respondents disagreed with the FASB’s proposed changes to the equity method of accounting, observing that the factors indicating when an investment that would otherwise qualify for the equity method of accounting must be accounted for at FV-NI because it is held for sale were too broad. That is, the proposed guidance might force equity securities to be viewed as held for sale when management has identified possible exit strategies and a date or range of dates at which time the entity might exit the investment even if the investments are in fact held for a longer term and possibly for strategic purposes. Many respondents would prefer having a fair value option to account for investments that would otherwise qualify for the equity method of accounting at FV-NI. In fact, most respondents were opposed to eliminating the unconditional fair value option.

The boards are expected to begin redeliberating key areas of potential convergence in July.

[1]    See Deloitte’s February 14, 2013, and April 16, 2013, Heads Up newsletters for more information.

[2]    See the FASB’s memorandum on the summary for more details.

[3]    IFRS 9, Financial Instruments.

[4]    IASB Exposure Draft ED/2012/4, Classification and Measurement: Limited Amendments to IFRS 9.

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