FASB Continues to Deliberate Classification and Measurement of Financial Instruments
At its June 8, 2011, meeting, the FASB made tentative decisions regarding the following two important aspects of the classification and measurement component of its project on accounting for financial instruments: (1) the initial measurement of financial instruments and (2) a fair value option for financial liabilities.
Initial Measurement of Financial Instruments
The Board addressed not only the initial measurement of financial instruments but also the treatment of transaction fees and costs and the accounting for differences between transaction price and fair value.
Initial Measurement Principle and Accounting for Fees and Costs
The Board unanimously voted to establish an initial measurement principle that is based on the subsequent measurement of the related financial instrument. That is, financial instruments subsequently measured at fair value through net income (FV-NI) would initially be measured at fair value and financial instruments subsequently measured at fair value through other comprehensive income (FV-OCI) or amortized cost would be measured at the transaction price initially.
This measurement principle results in differing treatment of transaction fees and costs depending on subsequent measurement. Such costs should be expensed when incurred for the acquisition or issuance of financial instruments initially measured at fair value (and subsequently measured at FV-NI). For the acquisition or issuance of financial instruments subsequently measured at FV-OCI or amortized cost and therefore initially measured at the transaction price, transaction fees and costs are included in the amount initially recognized.
As clarified in the FASB’s June 8, 2011, summary of the Board’s meeting decisions, entities that qualify as registered investment companies in accordance with the Investment Company Act of 1940, and that therefore apply the specialized industry guidance in ASC 946,1 initially measure financial instruments at the transaction price. The Board voted by a wide majority of 6 to 1 to retain this specialized industry guidance.
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Editor’s Note: Under the Board’s tentative decision, investment companies subsequently measure a financial instrument at fair value, with transaction fees and costs recorded in unrealized gains/losses until the instrument is sold, at which time such amounts are reclassified to realized gains/losses. This represents an exception to the initial measurement principle tentatively selected for financial instruments subsequently measured at FV-NI and initially measured at fair value. While most entities will expense transaction costs incurred for the acquisition or issuance of a financial instrument that is initially and subsequently measured at fair value, investment companies will be permitted to report transaction costs in unrealized gains/losses until the instrument is sold. |
Differences Between Transaction Price and Fair Value
The FASB’s May 2010 proposed ASU on accounting for financial instruments2 would have required entities to evaluate differences between the transaction price and fair value, identifying the elements in the transaction price that contribute to the difference, and to separately measure such elements. Paragraph 14 of the proposed ASU stated, in part:
If reliable evidence indicates that the transaction price differs significantly from the fair value, and the entity determines that the difference is at least partially due to the existence of other elements in the transaction . . . , the financial instrument and the other element(s) in the transaction shall be measured separately.
In its June 8, 2011, action alert, the FASB indicated that the Board tentatively “decided to develop a [different] principle that would require an entity to evaluate whether the consideration given or received at initial recognition indicates that another element exists other than the financial instrument.” During Board discussion, a related principle outlined in IFRS 93 was explored as a possible basis for the FASB’s new principle for the treatment of differences between transaction price and fair value (the Board requested the staff to further develop this principle within the framework of the proposed ASU). Paragraph B5.1.1 of IFRS 9 states, in part:
The fair value of a financial instrument at initial recognition is normally the transaction price (ie the fair value of the consideration given or received . . . ). However, if part of the consideration given is for something other than the financial instrument, the fair value of the financial instrument is estimated using a valuation technique . . . . Any [difference] is an expense or a reduction of income unless it qualifies for recognition as some other type of asset.
Fair Value Option for Financial Liabilities
At its April 6, 2011, meeting, the Board tentatively decided not to provide entities with an option to measure at FV-NI those financial instruments that would otherwise be classified and measured at amortized cost or FV-OCI. This decision was made in the context of financial assets. At its June 8, 2011, meeting, the Board unanimously rejected an unconditional fair value option for financial liabilities.
The Board did tentatively decide to provide a fair value option for financial liabilities in limited circumstances. Specifically, an entity holding financial liabilities that would require the host contract to be classified and measured at amortized cost could elect (at initial recognition) to instead measure hybrid instruments at FV-NI if doing so would allow the entity to avoid bifurcation once it has determined that an embedded derivative that otherwise would require bifurcation exists.
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Editor’s Note: The Board will decide whether a fair value option under similar conditions should also be pemitted for financial assets. |
The Board also decided that nonrecourse financial liabilities that will be settled through the use of financial assets should be measured in the same manner as the related financial assets. The settlement of obligations associated with failed sales and variable interest entities present two situations in which financial assets measured at fair value may be used to settle financial liabilities. Under the Board’s tentative decision, an entity would be required to measure related financial liabilities at FV-NI in these situations. There would not be an option.
The Board directed the staff to evaluate whether entities should be permitted or required to measure a group of financial assets and financial liabilities at fair value when such a group is managed together and its performance is evaluated on a fair value basis in accordance with the entity’s risk management or investment strategy.
For information about the Board’s previous tentative decisions on the classification and measurement of financial instruments, see Deloitte’s May 10, 2011, Heads Up newsletter and May 27 and June 1, 2011, journal entries.
[1] FASB Accounting Standards Codification Topic 946, Financial Services — Investment Companies.
[2] FASB Proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities.
[3] IFRS 9, Financial Instruments.
