Doug Bennett

Definition

The proposed update would apply to all financial instruments, except those classified as equity and a limited list of others. Financial instruments are defined as cash, evidence of ownership in an entity or a contract that imposes a contractual obligation to deliver cash or exchange other financial instruments on potentially unfavorable terms. Commonly held financial instruments include, but are not limited to, investments in debt and equity securities, trade receivables and payables, loans receivable, notes payable, deposit accounts at financial institutions and derivative contracts.

Background

FASB believes the current model for financial instruments accounting:

1. Is unnecessarily complex since it permits different accounting treatments for the same instruments
2. Lacks transparency in accounting for hedging relationships
3. Impedes timely recognition of impairment based on the high probability threshold that must be met

These weaknesses have been highlighted in the wake of the recent financial crisis.

Significant Provisions

The proposal seeks to simplify and improve financial reporting for financial instruments by developing a consistent framework, making changes to the requirements to qualify for hedge accounting and removing perceived impediments to recognizing impairment. Significant provisions include:

• Most financial instruments would be measured at fair value. One exception would be core deposit liabilities for financial institutions, which would be measured using an alternative present value approach. All changes in fair value would be recognized in earnings unless the business strategy is to hold for collection or payment, in which case an election may be made to report the changes in other comprehensive income (OCI). Most equity investments would not qualify for this election.
• An election also may be made to measure an entity’s debt at amortized cost if fair value measurement would create a mismatch between recognized assets and liabilities. Most short-term receivables and payables also could be measured at amortized cost. This exception would not be available for short-term lending arrangements or investments in short-term debt securities.

• Fair value, as defined in the Accounting Standards Codification, incorporates impairment assumptions as part of those measures. Therefore, financial instruments measured at fair value would not have a separate measurement for impairment. Financial instruments for which OCI or amortized cost treatment is elected would be subject to an impairment model based on shortfalls in expected cash flows. A probable event would no longer be required. Instead, entities would evaluate past history and current conditions and estimate the collectibility of contractual cash flows over the remaining life of the instrument.
• Hedge accounting would be available for qualifying financial instruments for which OCI or amortized cost treatment is elected. The risks that could be hedged would be the same as under previous standards. However, qualifying for hedge accounting would be easier because the relationship would only need to be reasonably, not highly, effective.
• The ability to assume no ineffectiveness under the shortcut method would be eliminated, but the trade-off would be significantly easier effectiveness assessments.

Industries Affected

The proposal applies to all industries. However, entities that hold significant volumes of financial instruments currently measured at amortized cost would be most significantly affected. Financial institutions, especially retail and commercial banks and thrifts, lead the list of those most significantly affected.

Effective Date

The proposal does not specify an effective date; FASB plans to determine the date based on feedback from constituents in the comment process. The proposal does prohibit early adoption, however, and nonpublic entities with less than $1 billion in total assets would receive a four-year deferral of certain provisions.

Summary

If adopted, FASB’s proposal will present significant relief to some financial statement preparers and significant challenges to others. Entities that engage in significant hedging activities will appreciate the simplicity of the new hedging model. Financial institutions with significant portfolios of loans and deposits currently measured at amortized cost will face significant challenges in developing and implementing accounting systems to reliably measure those instruments at fair value. The needs of financial statement users will ultimately drive whether the proposal moves forward to adoption.

Consult your BKD advisor with questions on how this landmark FASB proposal might affect you.