Classification and measurement of financial instruments — FASB decides cash flow characteristics test is unnecessary and limits fair value option
At its meeting last week, the FASB discussed its proposed ASU1 on the classification and measurement of financial instruments and made tentative decisions related to (1) the need for a contractual cash flow characteristics assessment and (2) the fair value option for hybrid financial instruments.
Cash Flow Characteristics Assessment
The FASB tentatively decided “not to incorporate a test to assess the cash flow characteristics of financial assets.” In addition, the Board indicated that it would tentatively “require equity investments to be measured at fair value with changes in the fair value recognized in net income . . . except for certain investments that are accounted for under the equity method of accounting and those that qualify for the practicability exception to fair value measurement.”
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Editor’s Note: It is unclear from the Board’s tentative decisions how entities would identify instruments as either debt or equity investments. The proposed ASU provides that an entity “may measure an equity investment without a readily determinable fair value . . . at its cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical investment or a similar investment of the same issuer.” This practicability exception does not apply to “a broker and dealer in securities that is subject to the guidance in [ASC] 940[2] or an investment company that is subject to the guidance in [ASC] 946.” It also does not apply to an investment that qualifies for “the practical expedient to estimate fair value in accordance with [ASC] 820-10-35-59.”3 |
Further, the FASB directed its staff to “identify any financial assets that, because of their complexity or risk profile, should be measured at [fair value through net income].” The Board indicated that it “would consider the classification and measurement for those instruments at a future meeting.”
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Editor’s Note: Since the Board decided not to incorporate a cash flow test, we expect it to consider whether additional guidance is needed for financial assets such as interest-only strips, principal-only strips, and beneficial interests in securitized financial assets that can contractually be prepaid or otherwise settled in a way that precludes the holder from recovering substantially all of its recorded investment. Currently, such assets are required to be measured in the same manner as investments in debt securities that are classified under ASC 320 as either available for sale (and accounted for at fair value through other comprehensive income) or trading (and accounted for at fair value through net income). |
Fair Value Option for Hybrid Financial Instruments
At the meeting, the FASB also tentatively decided “to allow a fair value option for hybrid financial instruments (both assets and liabilities) only when the entity has determined that the instruments contain embedded derivative features requiring bifurcation and separate accounting.”
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Editor’s Note: The Board’s tentative decision would permit an entity to irrevocably elect fair value, with changes in fair value recognized in earnings, to account for financial assets and financial liabilities that contain an embedded derivative that requires bifurcation and separate accounting in accordance with ASC 815-15. That is, an entity could choose not to bifurcate an embedded feature from a host contract and instead elect to measure the entire hybrid financial instrument at fair value. Regarding financial liabilities for which a fair value option has been elected, the Board will address at a future meeting whether changes in the entity’s own credit risk should be recognized in other comprehensive income, as was proposed in the February 2013 proposed ASU. In light of the Board’s tentative decision, entities may not be able to elect the fair value option for hybrid financial instruments whose embedded features do not require bifurcation. Accordingly, entities seeking to apply the fair value option may need to demonstrate that bifurcation would be required in the absence of such an election. |
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1 FASB Proposed Accounting Standards Update, Recognition and Measurement of Financial Assets and Financial Liabilities.
2 For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”
3 ASC 820-10-35-59 states that a “reporting entity is permitted, as a practical expedient, to estimate the fair value of an investment within the scope of [ASC] 820-10-15-4 through 15-5 using the net asset value per share (or its equivalent, such as member units or an ownership interest in partners’ capital to which a proportionate share of net assets is attributed) of the investment, if the net asset value per share of the investment (or its equivalent) is calculated in a manner consistent with the measurement principles of [ASC] 946 as of the reporting entity’s measurement date.”
