FASB on Thursday issued a revised proposal that would provide a comprehensive framework for classifying and measuring financial instruments.
The Proposed Accounting Standards Update (ASU), Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, would require financial assets to be classified and measured based on the asset’s flow characteristics and the entity’s business model for managing the asset, rather than on its legal form or whether the asset is a loan or security.
Financial assets would be classified into one of three categories:
- Amortized cost. This would include financial assets comprised solely of payments of principal and interest that are held for the collection of contractual cash flows.
- Fair value through other comprehensive income (OCI). This would include financial assets comprised solely of payments of principal and interest that are both held for the collection of contractual cash flows and for sale.
- Fair value through net income. This would include financial assets that do not qualify for measurement at either amortized cost or fair value through OCI.
Equity investments (except those accounted for under the equity method of accounting) would be measured at fair value with changes in fair value recognized in net income, because such investments do not have payments of principal and interest. A “practicability exception” to measurement at fair value would be provided for equity investments without fair values that can be readily determined.
Financial liabilities would generally be required to be carried at cost unless:
- The reporting organization’s business strategy is to subsequently transact at fair value, or
- The obligation results from a short sale.
The embedded derivative requirements for hybrid financial liabilities would be retained.
Public companies would be required to disclose fair values parenthetically on the face of the balance sheet for financial assets and financial liabilities measured at amortized cost, with exceptions for demand deposit liabilities and receivables and payables due in less than a year. Nonpublic entities would not be required to disclose this fair value information parenthetically or in the notes.
Comments on the proposal are due May 15.
“The proposed accounting standard would measure financial assets based on how a reporting entity would realize value from them as part of distinct business activities, while the measurement of financial liabilities would be consistent with how the entity expects to settle those liabilities,” FASB Chairman Leslie Seidman said in a statement.
Seidman said the revised proposal simplifies the classification methods currently in use and provides an opportunity for convergence with the proposal issued by the International Accounting Standards Board (IASB) in November.
If approved, the proposal would narrow the availability of the existing fair value option for financial assets and financial liabilities. In the limited cases where the fair value option would be allowed for financial liabilities, changes in the fair value attributable to an organization’s own credit risk would be reported in OCI rather than net income.
The proposal is part of a broader joint project with the IASB to improve and converge accounting for financial instruments, which has received significant scrutiny in the wake of the global financial crisis. FASB’s first exposure draft on financial instruments was issued in May 2010 and proposed a much greater use of fair value measurement for financial assets and financial liabilities than exists under current U.S. GAAP.
Investors, reporting entities, and other stakeholders told FASB that fair value information is not of primary relevance for loans, deposits, and financial liabilities. Based on that feedback, FASB decided to require amortized cost as a measurement attribute for assets held for collection of cash flows, because the value is realized over the holding period of the asset.
Assets that might be sold to manage interest rate risk or liquidity risk would not qualify for cost measurement. FASB also decided that financial liabilities would generally be measured at amortized cost unless certain conditions are met.
Accounting for expected credit losses on debt instruments carried at amortized cost or fair value through OCI is addressed in FASB’s ASU on credit losses, which was issued in December. Both ASUs are part of the broader financial instruments project.
The IASB issued a classification and measurement proposal for financial instruments in November and is expected to issue a credit loss proposal by the end of March. The IASB credit loss proposal is expected to use a different model than FASB’s and would provide limited convergence.
Ken Tysiac (
) is a JofA senior editor.