FASB Goes With 'Three-Buckets' Approach to Financial Instruments

The Financial Accounting Standards Board has reached a grand compromise on financial instruments.

After years of debate, FASB has finalized its proposal for a new way to account for financial assets and financial liabilities, calling for a mixed use of historical cost and fair value. Some changes in value will be recognized in earnings and others through equity, depending in large part on how a company manages or plans to use the instruments in question.

The new standard is meant to bring greater transparency and reduced volatility to corporate balance sheets. The model also narrows the use of fair value to book liabilities, which would address the puzzling effect in current rules where fair valuing a company's own debt as its creditworthiness diminishes can lead to gains in the income statement.

On the financial asset side, the proposed accounting standard will require companies to measure instruments based on which of three categories they fall into. Financial assets such as loans that consist only of payments of principal and interest that are held for the collection of cash flows would be measured at amortized or historical cost. Fair value with changes recognized in equity or “other comprehensive income” would be required for the same instruments when there's some possibility that the entity holding the instrument might consider selling it. The final category is for everything else, and those instruments would be measured at fair value with changes recognized in net income.

The proposal takes the approach currently used for debt and equity securities and applies it more broadly, says Sydney Garmong, a partner with Crowe Horwath. “The idea is to reduce the number of models and reduce complexity,” she says. As a result, the three “buckets” or categories described in the proposal should be familiar to preparers. The difference, she says, is in what instruments go into each of the three buckets.

The proposal is more explicit, for example, that amortized cost can only be used for instruments that are held to maturity, Garmong says. “The amortized cost or held-to-maturity bucket is really reserved for vanilla instruments,” she says. “Instruments will have to be evaluated carefully to determine whether the amortized cost bucket can actually be used.” Under the proposal, equity securities would be classified in the third bucket and measured at fair value, with changes recognized in the income statement. “All those changes in values have to flow through earnings,” she says. “Today that is not the case.”

On the liability side, the proposal will generally require companies to measure at amortize costs, except where a company expects to sell a debt at fair value or when the obligation results from a short sale.

The change most cheered by the investor and analyst community is the proposed restriction on the ability to record certain instruments at fair value, says Wallace Enman, vice president and senior credit officer at Moody's. When FASB adopted a standard in 2007 to give companies the option to mark their own debt to fair value, it created “a lot of noneconomic noise and volatility in the balance sheet and the income statement of banks,” he says. “Everyone who looks at banks is backing out the effect of the debt value adjustment,” he says. “From our perspective in particular, we generally assume firms will make good on their own obligations and not settle them at a discount.”

“The idea is to reduce the number of models and reduce complexity.”

—Sydney Garmong,

Partner,

Crowe Horwath

The proposed standard doesn't change how fair value is measured, however, which is another factor that, according to Enman, introduced noise. When FASB determined in 2007 that fair value should focus on exit values—or what an entity would get if it sold a particular asset or liability in an arm's length transaction—it required companies to consider their own credit worthiness when determining values for all liabilities measured at fair value, not just those for where the fair value option was applied. “That's not going away under this proposal,” he says.

Effect on Non-Financials

While the standard will have the greatest effect on accounting for financial institutions, especially those that deal heavily in financial instruments, there is plenty that could affect non-financial companies as well, says Jamie Mayer, managing director at Grant Thornton. “I've seen some large non-financial companies that have a lot of investments, so a lot of financial assets and financial liabilities,” he says. “They need to go through this proposal and think about their business model and the criteria. Where will things get classified? It may not be all that different from what they're doing today, but they need to do their homework and see where they fit into this model.”

PROPOSAL UPDATES

Below is an excerpt from Deloitte's summary of FASB's financial instruments proposal, explain how it will affect financial liabilities, fair value, and presentation.

Financial Liabilities

Financial liabilities are measured at amortized cost, with the following exceptions:

Short sale obligations are accounted for at fair value for which all changes in fair value are recognized as net income (FV-NI).

Financial liabilities for which the entity has a business strategy to subsequently transact at fair value (e.g., transfer the liability to a third party) are accounted for at FV-NI.

Nonrecourse financial liabilities that are contractually required to be settled with only the cash flows from related financial assets are accounted for on the same basis as the related financial asset (i.e., amortized cost, FV-OCI, or FV-NI).

Unlike financial assets, embedded derivatives in financial liabilities are separately accounted for at FV-NI if they are required to be separated under ASC 815-15 unless an entity elects to account for the hybrid financial liability in its entirety at FV-NI.

The issuer of a loan commitment, revolving line of credit, or commercial letter of credit would account for the commitment in the same manner as the underlying loan to be made under the commitment (i.e., amortized cost, FV-OCI, or FV-NI) provided the probability of exercise is not remote.

Fair Value Option

On initial recognition of a financial asset or financial liability, an entity may elect to account for certain financial assets and financial liabilities at FV-NI even if they would otherwise have been accounted for at amortized cost or FV-OCI. This option is available when:

Financial assets are held and managed in a hold-and-sell business model.

An entity manages the net exposure for a group of financial assets and financial liabilities on a fair value basis and provides net exposure information to its management.

A hybrid financial liability contains an embedded derivative that significantly modifies its cash flows provided it is clear with little or no analysis that separation of the embedded derivative is not precluded.

If an entity has elected the fair value option for a financial liability, any changes in fair value attributable to instrument-specific credit risk are recognized in OCI rather than in net income.

Presentation

On the face of the statement of financial position, an entity is required to present the following:

Financial assets and financial liabilities separately, grouped by measurement

category.

A separate line item for hold-to-collect financial assets that have been identified for sale.

Parenthetical fair value information for all financial assets and financial liabilities accounted for at amortized cost except for receivables and payables due in less than a year and demand deposit liabilities. This requirement does not apply to non-public entities.

Parenthetical amortized cost information for its own outstanding debt

instruments accounted for at FV-NI.

Source: Deloitte.

Non-financial companies that only trade in their accounts payable or accounts receivable may not see meaningful differences, says Adam Brown, a partner with BDO USA. “Most will think that's a good thing,” he says. For those companies, the more important changes might come if FASB resumes its work on a new standard for hybrid liabilities, or those with characteristics of both debt and equity. “That's the most broken part of the literature,” he says. “It's not at all clear or consistent.”

Faye Miller, a director with McGladrey, says the effect for non-financial companies depends heavily on their investment portfolio. “It's hard to generalize,” she says. “It will depend on the extent to which you have these financial instruments that aren't largely required through industry guidance to be carried at fair value with changes recognized in net income,” she says.

Generally, the proposal is expected to reduce complexity in some respects, but amp it up in others, says Bob Uhl, a partner with Deloitte & Touche. “The elimination of the distinction between debt securities and loans makes things less complex,” he says. However, the categorization of instruments according to a company's business strategy and the cash flow characteristics of an instrument could become complex, he says. “That's something we don't do today, so that will be adding complexity.”

Richard Martin, who heads financial reporting at the global Association of Certified Chartered Accountants, says FASB's approach to classification and measurement is closely converged with the approach under development at the International Accounting Standards Board. FASB's proposal allows a practicability exception for certain equities that are hard to value to be carried at historical cost, while the IASB proposal requires companies to use fair value.

The bigger concern, says Martin, is FASB and IASB are not converged on a separate but closely related proposal on credit impairment. FASB is encouraging companies to consider the financial instruments and credit loss proposals in tandem to get a comprehensive view of how changes in value will be reflected in financial statements. In Martin's view, the differences between FASB and IASB proposals on credit losses are problematic. “These boards have produced these proposals knowingly,” he says. “My expectation is they will probably go through as they stand, but we certainly hope that the final standards will end up more in the same place.”

FASB is accepting comments on the financial instruments proposal through May 15.