It’s been a long time coming, but the fourth quarter of 2015 is when the Financial Accounting Standards Board (FASB) is aiming to issue the final standards for both the Classification and Measurement Phase and the Impairment Phase of their Financial Instruments Project. The FASB is planning to issue an Exposure Draft on the third and final phase, Accounting for Financial Instruments: Hedging, in the fourth quarter, as well.
Divergence Wins in the End
It has been about 10 years now since the FASB, together with the International Accounting Standards Board (IASB), initially established joint objectives to improve and simplify the reporting for financial instruments. The Boards initially started their respective financial instruments projects with intentions for convergence and worked over the years to try to reach convergence. However, based on the decisions reached so far by the FASB, it now appears that convergence with IFRS will not happen on accounting for classification and measurement of financial instruments or accounting for impairment.
The IASB issued the complete version of IFRS 9 Financial Instruments in July 2014, marking the completion of all three phases on the international side. While IFRS 9 was completed in stages, earlier versions were eligible for early adoption on a stand-alone basis under certain conditions. However, upon issuance of the final version of IFRS 9, all previous versions are superseded by the comprehensive version, which is mandatory as of January 1, 2018.
While the IASB stuck with a principles-based approach, changing the accounting for classification and measurement so that it is driven by cash flow characteristics and the business model in which an asset is held, the FASB changed course and chose a limited amendment approach, opting for targeted improvements to current U.S. GAAP. In many cases, this will result in the classification and measurement under existing GAAP to remain intact.
For impairment, if you recall, after exploring various impairment models, both Boards seemed keen to the idea of a “three-bucket” approach based on expected credit losses and the extent of credit deterioration since initial recognition. IFRS 9 is based on this approach; however, the FASB changed their approach in 2012 and are pursuing a single, principles-based approach based on cash flows. This approach is known as the “Current Expected Credit Loss” (CECL) model. Still, although the IASB model and FASB model for impairment are different, both evolve the guidance from an incurred-loss model to an expected-loss model.
Here is a brief summary of what is expected on the FASB side when they issue final standards later this year on classification and measurement and impairment of financial instruments:
Classification and Measurement of Financial Instruments
The current classification and measurement guidance for debt securities, derivatives and loans is not expected to change. For equity securities with readily determinable fair values, there will no longer be an “available-for-sale” classification where subsequent changes in fair value are recorded in other comprehensive income. Most investments in equity securities that are not accounted for using the equity method of accounting will be required to be measured at fair value with subsequent changes in fair value recognized in net income. I indicated “most” because there is a practicability exception for equity securities without a readily determinable fair value that would result in measurement at cost minus impairment, if any, adjusted for changes resulting in observable price changes.
Entities would still be able to elect the fair value option in ASC Topic 825 for both financial assets and/or financial liabilities; however, for financial liabilities measuring using the fair value option, entities should present the portion of the total change in fair value caused by a change in instrument-specific credit risk separately in other comprehensive income. Any resulting accumulated gains and losses will need to be recycled from accumulated other comprehensive income to earnings when the financial liability is settled before maturity.
Some additional changes are expected regarding presentation and disclosure guidance and the evaluation of the valuation allowance on a deferred tax asset related to debt securities classified as available for sale.
Impairment of Financial Instruments
While changes to classification and measurement are not expected to be as onerous as initially proposed, changes to credit impairment are expected to be significantly different than the current U.S. GAAP model for certain financial assets.
For loans, trade receivables, held-to-maturity debt securities and certain other financial assets that are measured at amortized cost, an entity will be required to apply the “Current Expected Credit Loss” (CECL) Model. This model requires recognition of an allowance for management’s current estimate of cash flows that it does not expect to collect over the life of the instrument (i.e., lifetime expected credit losses) versus the current requirement of incurred losses.
The current other-than-temporary impairment (OTTI) model for available-for-sale classified debt securities would be modified. Targeted improvements relate to removing requirements to consider certain factors when determining whether an impairment should be recognized. The more prominent change is that an allowance approach will be required versus the current requirement for a direct write-down of the cost basis of the security. Under this approach, an entity would be allowed to recognize reversals in credit losses.
Another significant change to expect relates to the accounting for purchased credit-impaired (PCI) financial assets. The current guidance in ASC Topic 310-30 related to PCI financial assets is expected to be eliminated. Instead, an entity must recognize an allowance for expected credit losses it acquires. The initial cost basis of the PCI asset would equal the sum of the purchase price and the estimate of expected credit loss as of the acquisition date. Subsequent accounting for PCI assets would be simplified from existing current guidance as the accounting would not differ but be the same as for originated loans (application of the CECL model).
Lastly, as would be expected with a significant model change, disclosure requirements will be revised, most likely resulting in expanded disclosures.