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FASB Continues Redeliberations on the Classification and Measurement of Financial Instruments

Published on: 08 Apr 2011

At its April 6 Board meeting, the FASB continued its discussions of the classification and measurement portion of its project on accounting for financial instruments, reaching tentative decisions about the following: (1) certain refinements to the business strategy criterion for classifying and measuring financial instruments and (2) hybrid financial instruments.

Business Strategy Criterion

The Board’s discussion focused on the following attributes of the business strategy criterion: (1) application (i.e., whether the business strategy criterion should be assessed on an instrument-by-instrument basis or at a higher level of application) and (2) characteristics of the criterion.

Application

The Board tentatively concluded that, as with the requirements in its original proposal,1 an entity should apply the business strategy at a higher level of aggregation rather than on an instrument-by-instrument basis.

Characteristics

The Board discussed whether to further refine and clarify the descriptions of the classification and measurement categories2 under the business strategy criterion, tentatively deciding to define the FV-NI, FV-OCI, and amortized cost categories as described below. The Board intends to use these descriptions to assist with other considerations in the overall development of the classification and measurement model for financial instruments. The FASB’s Action Alert describes the three categories as follows:

Amortized Cost Category

The business activity for these financial instruments must meet all of the following conditions:

1. Financial instruments issued or acquired for which an entity’s business strategy, at origination or acquisition of the instrument, is to manage the instruments through customer financing (lending or borrowing) activities. These activities primarily focus on the collection of substantially all of the contractual cash flows from the borrower or payment of contractual cash flows to the lender.

2. Financial instruments for which the holder of the instrument has the ability to manage credit risk by negotiating any potential adjustment of contractual cash flows with the counterparty in the event of a potential credit loss. Sales or settlements would be limited to circumstances that would minimize losses due to deteriorating credit.

3. Financial instruments that are not held for sale (assets) or transfer (liabilities) at acquisition or issuance.

FV-OCI (Fair Value — Other Comprehensive Income) Category

The business activity for these financial instruments must meet all of the following conditions:

1. Financial assets issued or acquired in a business activity for which an entity’s business strategy, at origination or acquisition of the instruments, is to invest the cash of the entity either to:

a. Maximize total return by collecting contractual cash flows or selling the instrument

b. Manage the interest rate or liquidity risk of the entity by either holding or selling the instrument.

2. Financial assets that are not held for sale at acquisition or issuance.

FV-NI (Fair Value — Net Income) Category

The business activity for these financial instruments must meet either of the following conditions:

1. Financial instruments that are held for sale (assets) or transfer (liabilities) at acquisition

2. Financial instruments that are actively managed and monitored internally on a fair value basis but do not qualify for the FV-OCI category.

 

Editor’s Note: During discussions, the Board considered whether to define all three classification and measurement categories or to treat FV-NI as the default category. Several Board members expressed concerns that not defining the FV-NI category would result in an unrestricted fair value option for all financial assets and financial liabilities (i.e., an entity could elect to classify a financial instrument in the FV-NI category even if it meets either the FV-OCI or amortized cost criteria). Accordingly, the Board decided to define all three categories; however, the Board’s decision about the use of the FV-NI category for financial liabilities is tentative. The Board instructed the staff to bring issues associated with the classification and measurement of financial liabilities for discussion at a future meeting. The Board also plans to discuss a restricted fair value option for financial assets and financial liabilities at that meeting.

Hybrid Financial Instruments

The Board tentatively decided to retain the bifurcation requirements in ASC 815-153 for embedded derivatives in hybrid financial instruments. Therefore, in a manner consistent with current GAAP, an embedded feature that meets the bifurcation requirements in ASC 815-15 would need to be bifurcated and accounted for separately as a derivative instrument. The Board noted that this decision is an “interim decision” since the FASB is working on further developing its overall classification and measurement model. In addition, the Board indicated that it may explore an alternative model for hybrid instruments at a later date when it meets with the IASB to discuss convergence on the financial instruments project.

Editor’s Note: This tentative decision represents a change from the Board’s original proposal, which would have required an entity to classify the hybrid instrument at FV-NI or FV-OCI on the basis of certain criteria. In other words, under the original proposal, the embedded derivative feature would not have been separated; instead, the presence of an embedded derivative feature would have caused the entire hybrid instrument to be measured at either FV-NI or FV-OCI.

For additional information about the previous tentative decisions the Board has reached during its redeliberations of the classification and measurement of financial instruments, see Deloitte’s January 25, 2011, and March 3, 2011, journal entries.

 

 

 

[1] Proposed FASB Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities.

[2] Classification and measurement categories include (1) fair value through net income (FV-NI), (2) fair value through other comprehensive income (FV-OCI), and (3) amortized cost.

[3] FASB Accounting Standards Codification Subtopic 815-15, Derivatives and Hedging: Embedded Derivatives.

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