August 2, 2013
Volume 20, Issue 24

by Magnus Orrell, Jason Nye, and Sean Prince, Deloitte & Touche LLP

Introduction

On May 15, 2013, the comment period ended on the FASB’s proposed ASU¹ on the recognition, classification, measurement, and presentation of financial instruments.² The proposal, which affects all entities that hold financial assets or owe financial liabilities, generated approximately 150 comment letter responses. In addition to reviewing these responses, the FASB staff performed targeted outreach, speaking with preparers, auditors, regulators, and financial statement users to gather further input on the proposal.

The opinions expressed by respondents reveal disparate views among the various stakeholders. The mixed feedback poses a potential challenge to the FASB as it seeks to improve the classification and measurement of financial instruments under U.S. GAAP while still achieving convergence with IFRS 9.³

This Heads Up discusses themes in the feedback on the FASB’s proposed ASU. The Appendix to this Heads Up summarizes the feedback received by the IASB in response to its limited proposals to amend IFRS 9.

Observations Related to the Proposed Model

Themes in the feedback included:

• Support among respondents, including both users and preparers of financial statements, for the proposed ASU’s stated objectives, tempered by the view of many that the proposed ASU does not fully meet those objectives. For example, some suggested that the proposed ASU would merely replace existing accounting complexity with new accounting complexity (e.g., the proposed ASU would eliminate the embedded derivative requirements for financial assets but introduce new cash flow characteristics criteria) and would not result in full convergence with IFRSs.
• Support among many preparers for the introduction of a business model assessment for classifying financial assets. However, many would prefer that this assessment be the primary or sole basis for classification. Further, many suggested eliminating the proposed contractual cash flow characteristics assessment.
• Strong support among users (in contrast to preparers) for the dual-assessment model.

The Contractual Cash Flow Characteristics Assessment

Many preparers recommended eliminating the proposed contractual cash flow characteristics assessment altogether. Generally, these preparers proposed 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, with changes recognized in earnings. 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.

In addition, many preparers expressed concern that the contractual cash flow characteristics assessment could force entities to use fair value accounting for hybrid financial assets with de minimis or otherwise immaterial features that fail the cash flow characteristics assessment. Preparers also noted that there might be an increased restatement risk as a result of an entity’s accidentally overlooking nonsubstantive features that fail the assessment. Further, respondents expressed concern about applying the contractual cash flow characteristics test to purchased credit-impaired (PCI) assets because the proposed definition of “principal amount” might force many PCI assets to be accounted for at FV-NI.⁴

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 too 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.

Some respondents also disagreed with the proposed provision stating that for beneficial interests to pass the contractual cash flows assessment, such interests must have credit risk equal to, or less than, the average credit risk of the underlying pool. These respondents observed that as a result of this criterion, there could be fewer beneficial interests that qualify for amortized cost or FV-OCI under the proposed ASU than there would be under existing GAAP.

Several respondents indicated that if the FASB retains the contractual cash flow characteristics assessment, it should improve the assessment by:

• 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 respondents recommended not providing a definition on the grounds that the term is well understood in practice).
• Modifying the definition of “interest” to include not only the time value of money, compensation for credit risk, and liquidity premiums but also profit margins, funding costs, and servicing costs.
• Defining “time value of money.”
• Ensuring that features unrelated to credit risk, leverage, or interest rate resets that are either likely to have only a small effect on cash flows or 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.

The Business Model Assessment

Respondents generally supported requiring entities to assess the business model in which they manage financial assets when they are determining how an asset should be classified. In fact, many respondents advocated using the business model assessment as the primary or sole basis for classifying financial assets. However, respondents expressed the following concerns:

• Differences between the proposed ASU’s application guidance on the business model assessment and the guidance in both IFRS 9 and the IASB’s proposed amendments in ED/2012/4 could lead to divergence in practice (although the underlying principles appear to be converged).
• The proposed ASU’s application guidance on sales out of an amortized cost business model may be too restrictive — some respondents prefer the related application guidance in IFRS 9 that permits (1) infrequent sales if the volume is not significant or (2) sales of a greater volume if they occur infrequently.
• The business model objective of the FV-OCI category is unclear — for example, some respondents noted uncertainty about the level of sales that would be permissible.
• There may not be a conceptual basis for the recognition of gains and losses in other comprehensive income (although respondents generally supported the FV-OCI category).

Some respondents requested clarification about the level at which the business model assessment should be performed (e.g., at a portfolio or business unit level or at the entity level) and about the interaction between such assessment and the proposed ASU’s requirement to reclassify financial assets when there is a change in business model.

Finally, some respondents observed that the proposed ASU is unclear about how an entity should classify and measure pools of financial assets it has acquired or issued when (1) the entity intends to hold a portion of the pool to collect contractual cash flows and to sell a portion of the pool and (2) the specific assets that will be held or sold are not identified at initial recognition. The proposed ASU would require entities to allocate portions of such pools to appropriate categories; however, it does not specify whether the portions would be allocated on a pro rata basis (i.e., portions of individual assets) or on the basis of whole instruments. This lack of clarity may complicate an entity’s impairment analysis for allocated, or proportionally allocated, debt instruments and for reclassifications as a result of a change in business model.

Other Comments

Financial Liabilities

With certain exceptions, respondents strongly agreed with the FASB’s proposal to require entities to account for financial liabilities at amortized cost. However, many nonusers of financial statements advocated retaining the 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.

Accounting for Equity Investments

Although the FASB seeks to retain much of the guidance under existing GAAP on investments that qualify for the equity method of accounting, the Board proposes to eliminate the fair value option for such investments and to require entities to account for an equity investment at FV-NI when the investment is held for sale at the time that it would otherwise qualify for the equity method. Under the proposed ASU, equity-method investments that are held for sale would include those for which an entity has identified (1) potential exit strategies and (2) a date or range of dates when the entity would exit the investments. A majority of respondents disagreed with the proposed change, noting that such factors are too broad and would apply to investments that an entity may intend to hold for strategic purposes on a long-term basis.

A practicability exception in the proposed ASU would permit entities to account for equity investments without readily determinable fair values at cost adjusted for impairment and observable price changes from transactions in identical or similar equity interests of the same issuer. Most respondents supported this exception.

Views were mixed on the proposed impairment model for investments accounted for under the equity method and equity investments measured under the practicability exception. Some respondents supported the proposed single-step approach, which would require a qualitative assessment of impairment indicators that may trigger measurement and recognition of differences between the equity investment’s carrying amount and fair value. Others, however, supported retaining the existing other-than-temporary impairment model or requiring subsequent reversals. Further, some observed that applying the single-step impairment model to equity-method investments could effectively result in measuring such investments at the lower of equity-method valuation or fair value.

Fair Value Option

Many preparers disagreed with the FASB’s proposal to eliminate the fair value option currently in ASC 825,⁵ which, subject to limited conditions, can be applied to financial assets and financial liabilities. They noted that they preferred the current guidance to the FASB’s proposed, more restrictive, fair value option. Other respondents suggested that the FASB align its fair value option criteria with those proposed by the IASB.

Presentation and Disclosure

Preparers and users were split on the proposed requirement to present parenthetically, on the face of the statement of financial position, fair value information for instruments at amortized cost. Users strongly supported this proposal, whereas most preparers did not.

However, preparers and users were generally aligned in supporting the proposed requirement to present separately, in other comprehensive income, changes in fair value attributable to changes in the entity’s credit risk for financial liabilities accounted for at FV-NI under the fair value option. Some respondents even requested that the requirement apply to financial liabilities for which accounting at FV-NI is mandatory, not merely optional.

Respondents expressed concerns about many of the other proposed presentation and disclosure requirements. For example, several respondents observed that the statement of financial position may be cluttered if entities are required to present financial instruments separately by classification category. In addition, as described in a FASB agenda paper, a few respondents noted that the contemplated disclosure requirements were “voluminous [and] operationally burdensome, and would not provide incremental benefit to the users of the financial statements.”

Next Steps

At a joint meeting of the FASB and IASB on July 23, 2013, staff members announced that the boards plan to redeliberate topics related to their proposals for classifying and measuring financial instruments at upcoming joint meetings as follows:

In addition, each board will separately redeliberate matters specific to its proposals. The IASB plans to separately redeliberate only its limited proposed amendments to IFRS 9; its staff projects that the IASB will complete the process by the end of 2013. The FASB will separately redeliberate other aspects of its more comprehensive proposals; it expects to issue a final ASU in the first quarter of 2014.

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