On May 26, 2010, the Financial Accounting Standards Board (FASB) issued an exposure draft (ED) of proposed Accounting Standards Update (ASU) Accounting for Financial Instruments and Revisions to Accounting for Derivative Instruments and Hedging Activities-Financial Instruments. The comment period ended September 30, 2010. The objective of the proposed guidance was to provide an improved and consistent financial reporting model for the recognition, measurement, and presentation of financial instruments in an entity’s financial statements. During exposure, the proposed ASU faced widespread opposition, especially concerning the requirement that all financial instruments, including loans, be accounted for at fair value. The AICPA Financial Reporting Executive Committee (FinREC) submitted a comment letter in response to the proposed ASU, voicing many of the concerns taken by other respondents.
The widespread opposition to fair valuing loans led the board to eventually revise its decision, recommending the use of a business activity approach to determine how to account for financial assets. It also decided 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. This was a major change for the direction of the project, and based on this decision, most loans could continue to be carried at amortized cost.
FASB’s Financial Instruments Project, which addresses recognition and measurement of financial assets, impairment, and hedging, is a major building block of the ongoing convergence of U.S. and International Financial Reporting Standards (IFRS) generally accepted accounting principles (GAAP). The project is garnering attention from both the International Accounting Standards Board (IASB) and FASB as they continue their discussions to resolve their differences and reach some agreement. Although the original goal was to complete this part of the convergence project in June 2011, the boards agreed to extend the timetable for the completion of the remaining priority convergence projects, including financial instruments beyond June 2011 to permit further work and input from stakeholders. This is a complex area, and, as such, the proposed ASU addresses several important components.
Who Would Be Affected by the Proposed Guidance?
All entities that have financial instruments would be affected by the proposed ASU. However, the extent of the effect would depend upon the relative significance of financial instruments to an entity’s operations and financial position as well as the entity’s business strategy. Undoubtedly, the effect will be based on the mix of assets of a particular entity, and, therefore, it is probable that it would be less significant for many commercial and industrial entities as well as for many not-for-profits. The burden on some traditional banking-type institutions will likely be reduced because the requirement to fair value the loan portfolio will no longer exist based on the criteria based on a business activity. As originally proposed, nonpublic entities with less than $1 billion in total assets have an additional four years to implement the new requirements relating to loans, loan commitments, and core deposit liabilities that meet certain criteria. The list of transactions not included in the proposed ASU is extensive; the following list provides some transactions that are not in the scope:
• An instrument held or issued by an entity that is classified in its entirety in the entity’s stockholders’ equity
• An equity component that has been bifurcated from a hybrid instrument and classified in an entity’s stockholders’ equity or that requires separate accounting for the component of a hybrid financial instruments
• Most insurance contracts within the scope of FASB Accounting Standards Codification (ASC) 944, Financial Services–Insurance
• An equity investment in a consolidated subsidiary (see FASB ASC 810-10 on consolidation)
• A loan commitment and a financial standby letter of credit held by a potential borrower
However, because it is likely that any final standard would be revised considerably from the proposed ASU issued in May 2010, it is difficult to predict which transactions will continue to be excluded from the scope.
What Was the Impairment Proposal?
Objectives of the Supplementary Document
In an ongoing effort to resolve the differences between U.S. GAAP and IFRS on the narrow issue of impairment, in January 2010, a joint supplementary document (SD) was issued to solicit input on a proposed impairment model. The proposals in this SD are designed to address a narrow part (credit impairment) of IASB’s and FASB’s projects to revise the requirements in IFRSs and U.S. GAAP for accounting for financial instruments and to move toward convergence. For IFRSs, these proposals will be combined with the proposals on amortized cost measurement that were included in IASB’s original ED after redeliberations on the second phase of its project, replacing International Accounting Standards 39, Financial Instruments: Recognition and Measurement, are completed. For U.S. GAAP, these proposals will be combined with the proposals on the remaining portions for accounting for financial instruments that were included in the original version of FASB’s proposed ASU, issued in May 2010. The IFRS has decided to delay the effective date of IFRS 39, presumably to allow enough time for the IASB and FASB to reach consensus on the issues for convergence.
FASB has continued to place primary importance on ensuring that the amount of the allowance for credit losses is adequate to cover expected credit losses before they occur, while IASB has continued to stress the importance of reflecting the relationship between the pricing of financial assets and expected credit losses. This proposal was an attempt by both boards to find a common solution to the impairment of financial assets. FinREC prepared a response to the SD.
Responses to the Supplementary Document
The comment deadline for this SD was April 1, 2011, and the responses received to date show the differences in the perspective of those entities that report using U.S. GAAP and those using IFRS, but both constituencies cited the need for field testing and more time to consider the implementation issues and readability of the proposal.
FinREC issued a comment letter on the proposal, reiterating its support for an incurred loss model, but it urged the boards to give respondents more time to consider the implementation issues and other issues raised. FinREC cited many issues not addressed in the SD that must be included in any future proposal. In its comment letter, FinREC also reiterated the need for re-exposure concluding with the following recommendations:
Again, we urge the Board not to finalize a standard on impairment of financial instruments before another ED is exposed for comment that addresses financial instruments comprehensively, including classification and measurement, providing guidance and clarity on the issues contained in the SD, as well as those issues that still need to be addressed and provides sufficient time for field testing. Although we recognize the need for convergence, the current proposal does not address many issues and may not be conceptually sound. Due to the short comment deadline, we do not have sufficient data to provide adequate input, which makes it difficult to determine whether this proposed Standard would work in practice.
The Three Bucket Approach
As a result of this process, in June 2011, the Boards introduced the three-bucket approach to impairment, agreeing that financial assets would progress through each of these buckets based on a credit-risk management approach. The discussions on this model continue, particularly with respect to the operational issues. The following are the three buckets envisioned in this model for the purpose of evaluating financial assets for impairment. The objective of Bucket 1 is to provide adequate reserves for losses that are expected over the next 12 months; the measurement of impairment in Buckets 2 and 3 would be based on lifetime losses.
Where Do We Go From Here?
The boards continue to discuss the classification and measurement issues, as well as impairments. The boards have not as yet discussed the input they have received on the hedging exposure draft. The boards have decided that the recognition and measurement and impairment proposals will take priority over hedging.
These decisions are tentative and no decisions have been made on re-exposure or a definite timetable. The current expectation is that both the classification and measurement and impairment segments of the financial instruments project will be re-exposed (either as separate documents or as a single exposure draft) in the second half of 2012. Many operational issues have yet to be resolved and this will impact the timeline. It is expected that hedging segment will be issued separately and at a later date.
The AICPA and FinREC continue to monitor the discussions of the boards to ensure that we provide our members with the latest information and how that will impact them. At this point it is difficult to determine if and when another comprehensive ED will be issued to address all the topics of concern or when a final standard may be issued. We do understand that is the highest priority on the agenda for both boards, but it is an extremely complex area without an easy solution.