FASB Retreats on Fair Value for Financial Instruments

Fair-value accounting for financial instruments has proved to be the third rail of accounting standards.

Most recently, the Financial Accounting Standards Board is taking a step back from earlier plans to require financial firms to mark all instruments to market prices. Instead, FASB has introduced what some are calling the “three buckets” solution. The proposal calls for banks and others that use financial instruments to designate three categories of financial assets or liabilities, each with different valuation criteria.

The move takes FASB closer to its goal of rolling out a single, global answer for how to account for financial instruments —a critical focal point for fixing problems that contributed to the financial crisis and achieving reporting consistency with countries abroad. But FASB still has a long way to go to meet a mid-2011 target date for a final solution that will make everyone happy.

Some influential advocacy groups like the CFA Institute have pushed for a full fair-value approach. But banks in particular howled that fair value doesn't reflect the way they manage many assets and liabilities, especially loans that may be producing cash flows but wouldn't fetch an equivalent amount on the open market.

FASB's original idea not only irked banks and other financial institutions, but it didn't square with international rules either, at a time when convergence of U.S. and international standards is a priority for U.S. regulators. The International Accounting Standards Board has already adopted International Financial Reporting Standard No. 9, Financial Instruments, which calls for a combination of fair value and amortized cost, or the amount paid then written down over time, to account for financial instruments.

FASB's latest idea for financial assets is to create three buckets. The first bucket is for assets held for sale, which would be recorded at fair value with changes reflected in net income. The second is for assets held as investments, to be measured at fair value with changes recorded through equity on the balance sheet. The third category is for assets held to collect cash flow, such as loans, which would be booked based on historical cost and written down over time to reflect settlement. “FASB's approach feels appropriate,” says Charlie Soranno, managing director for consulting firm Protiviti. “It matches the accounting to the economic realities of the transaction.”

GAAP currently provides three categories for the same three types of assets, but it appears FASB may consider some different criteria for what goes into each bucket, says John Bishop, a partner with PwC. “My sense is today's model is very form based,” he says. “The determination of which measurement model to use is based on the legal form of the arrangement. Their proposal, I suspect, will be based on the substantive characteristics of the instrument. … One would wonder whether if this is introducing enough change to U.S. GAAP to justify what may be an administrative burden of implementation,” says John Bishop, a partner with PwC.

International Departure

“An expected loss model comes a long way toward an economically grounded view of what future losses should be recorded instead of a legalistic view of what the incurred known losses are.”

—Jerry Arcy,

Managing Director,

Duff & Phelps

The three-bucket model eases tension in the United States, says Bob Uhl, national director of accounting standards and communications for Deloitte & Touche, but it doesn't necessarily ease tension with international rules. IFRS 9 is a two-bucket model, he says, with no middle category as FASB proposes for investment-like instruments. “Is that going to put pressure on the International Accounting Standards Board?” Uhl wonders. If FASB were to follow through with its three-bucket plan, “Will companies in Europe put pressure on the IASB to open up IFRS 9 again?”

FASB still has to work out some big issues on how its model will work, says Faye Miller, director of the national professional standards group for RSM McGladrey. The board has to define criteria for what fits into each bucket, she says, and it still has to sort out what to do with financial liabilities. “There are still some big uncertainties, but this is a major win from the perspective of financial institutions that were up in arms about this,” she says.

The concession on fair value may have been paved by an earlier decision. FASB and IASB are getting closer to a common approach to accounting for impaired assets, or determining when to write down the value of an instrument, says Adam Brown, a partner with audit firm BDO USA. Current accounting rules for U.S. GAAP and IFRS focus on reflecting impairments when losses actually occur, not anticipating them even if an entity has good reason to believe losses will occur.

FINANCIAL INSTRUMENT DISCUSSION

The following excerpt is from FASB's "Summary of Board Decisions" regarding financial instruments and what steps the board has taken since garnering public company feedback:

At the December 21, 2010 meeting, the Board decided that both the characteristics of the financial asset and an entity's business strategy should be used as criteria in determining the classification and measurement of financial assets. At that meeting, the Board also tentatively decided to consider three categories for financial assets:

1. Fair Value–Net Income (FV-NI)—Fair value measurement with all changes in fair value recognized in net income

2. Fair Value–Other Comprehensive Income (FV-OCI)—Fair value measurement with qualifying changes in fair value recognized in other comprehensive income

3. Amortized Cost

At this January 25, 2011 meeting, the Board discussed the business strategy criterion to determine which financial assets would be measured at amortized cost. The Board decided that a business activity approach should be used and that financial assets managed through a lending or customer financing activity that an entity holds for the collection of contractual cash flows should be measured at amortized cost.

The Board also decided that for all other business activities, financial assets should be measured at fair value. The Board decided that financial assets for which an entity's business activity is trading or holding for sale should be classified in the FV-NI category and that financial assets for which an entity's business activity is investing with a focus on managing risk exposures and maximizing total return should be classified in the FV-OCI category.

The Board requested the staff to refine which business activities would qualify for each classification and measurement category. Additionally, the Board requested the staff to evaluate how various types of financial assets would be classified on the basis of the refined criterion.

The Board also discussed the following:

1. Whether reclassifications between the three categories noted above should be permitted or required

2. Whether subsequent sales of financial assets classified at amortized cost would call into question or “taint” the remaining financial assets classified in the amortized cost category

3. Whether changes in fair value that have been recognized in other comprehensive income should be recognized in net income when such gains or losses are realized from sales or settlements.

Source

Financial Accounting Standards Board (Jan. 26, 2011).

FASB and IASB both had ideas about moving toward an “expected loss” model, rather than focusing on incurred losses, but they had different ideas about how to get there. More recently, the two boards issued a joint proposal to supplement their original separate proposals, mingling elements of their original ideas into a single model. “Now they're proposing something that's more aligned,” says Brown.

Jerry Arcy, a managing director for valuation firm Duff & Phelps, says the focus on expected losses rather than incurred losses answers one of the big criticisms of accounting rules arising from the economic crisis. “The average person on the street had a degree of concern about how healthy the banking and insurance environment were and whether regulators and management were asleep,” he says. “An expected loss model comes a long way toward an economically grounded view of what future losses should be recorded instead of a legalistic view of what the incurred known losses are.”

Hedge accounting, another key element of FASB's proposal, is also a work in progress. FASB's proposal followed the same basic model already contained in GAAP, but eliminated some of the more rigorous elements that made hedge accounting complex and difficult to follow, says Uhl. IASB, however, developed a different model that its constituents generally liked. “That will put pressure on FASB to open up their model,” he says. FASB has issued a discussion paper on IASB's proposal in order to get reactions from U.S. constituents.

While IASB remains committed to the June 2011 target date to finalize any changes to IFRS to accommodate countries that are adopting IFRS for the first time, FASB has begun to couch its target date. In a recent Webcast on a variety of FASB initiatives, Chairman Leslie Seidman said the goal for completion is still June 2011, but she emphasized that the quality of the final standard is a higher priority than a completion date.