Classification and Measurement of Financial Instruments — FASB and IASB Tentatively Agree on Cash Flow Characteristics Assessment
At their joint meeting on February 28, the IASB and the FASB (the "boards") tentatively decided to:
- Align the assessment of contractual cash flow characteristics of financial assets in the FASB's tentative model for the classification and measurement of financial instruments with the assessment in IFRS 9, Financial Instruments.
- Address application questions that the IASB has received related to that assessment.
The details of these tentative decisions are summarized below.
The boards expect to discuss business model assessment at their next meeting in March and other issues, such as bifurcation of financial assets, at subsequent meetings.
Cash Flow Characteristics Assessment
The boards tentatively agreed that, in a manner consistent with IFRS 9, a financial asset could be eligible for a measurement category other than fair value with all changes in fair value recognized in net income (FV-NI) if, at initial recognition, the "contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest [(P&I)] on the principal amount outstanding" (paragraph 4.1.2(b) of IFRS 9). Principal is the amount transferred at initial recognition adjusted for any discount or premium, and "interest is consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time" (paragraph 4.1.3 of IFRS 9). The objective of this guidance, as outlined by the boards' staffs, is to identify simple debt instruments that could be eligible for a measurement category other than FV-NI.
Assessment of Economic Relationship Between Principal and Interest
The boards also tentatively decided that when a financial asset's contractual terms give rise to cash flows that are solely payments of P&I, but the economic relationship between interest and principal is modified, an entity should consider the effect of the modification when assessing whether the cash flows are still consistent with the notion of solely P&I. Examples of features that could alter the economic relationship between interest and principal may include those that cause the interest rate to be reset at a frequency that does not match the tenor of the rate to which interest is reset or that create leverage. When a modifying feature creates more than insignificant differences between the cash flows of a benchmark financial asset1 and the financial asset being assessed, the financial asset being assessed should be measured at FV-NI.
Prepayment and Extension Options
The boards tentatively decided that financial assets with prepayment or extension options, including those that are contingent, could be eligible for a measurement category other than FV-NI as long as these features are consistent with the notion of
solely P&I.
Contingent Cash Flows
The boards tentatively decided that a contractual term that changes the timing or amount of payments of principal and interest would not preclude the financial asset from a measurement category other than FV-NI as long as any variability only reflects changes in the time value of money and the credit risk of the instrument. The probability of contingent cash flows that are not solely P&I should not be considered. Financial assets with contingent cash flows that are not solely P&I would be measured at FV-NI. An exception, however, will be made for extremely rare scenarios.
Going Forward
On the basis of the tentative decisions made, the FASB will amend its tentative model for the classification and measurement of financial instruments, and the IASB will:
- Make minor amendments to IFRS 9 to require an assessment of any feature that "modifies" the economic relationship between interest and principal, as described above.
- Modify the application guidance in paragraphs B4.1.9 of IFRS 9 on the analysis of leverage, and in B4.1.13 on variable interest rate features, to be consistent with the requirement in (1).
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Editor’s Note: The FASB may need to separately deliberate what, if any, characteristics criterion should be applied to financial liabilities. The instrument characteristics criterion in the FASB’s tentative model thus far has been applied to both financial assets and financial liabilities. However, the cash flow characteristics assessment that the FASB tentatively agreed to use in its model, as described above, applies only to financial assets. |
For more information about the boards’ previous tentative decisions on the classification and measurement of financial instruments, see Deloitte’s January 5, 2012, Heads Up and January 30, 2012, journal entry.
[1] According to a staff paper prepared for this meeting, a benchmark instrument is “a comparable ‘perfect’ instrument that has contractual cash flows that are solely P&I, [having] the same credit quality and with the same terms [as the instrument being assessed] except for the contractual term under evaluation.”
