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Some Details Are Added to Proposed Guidance for Classification and Measurement

November 21, 2013

The FASB and IASB addressed several questions about their proposals to classify and measure financial instruments.The boards didn’t make any fundamental changes to their proposals but agreed to clarify some details for their guidance.

The FASB and IASB on November 20, 2013, addressed some of the toughest questions on their effort to revamp the classification and measurement of financial instruments.

Meeting via videoconference, the boards attempted to clarify what they meant by “business model,” how to determine which instruments qualify for amortized cost measurement, and how to define the types of assets that would be measured at fair value with changes recorded in other comprehensive income.

The boards didn’t make fundamental changes to the models they proposed, but rather filled in some details for the guidance and tried to make their intentions clearer.The topics that were addressed were among the most frequently questioned in comments to the FASB’s Proposed Accounting Standards Update (ASU) No. 2013-220,Financial Instruments—Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities,and the IASB’s Exposure Draft (ED) No. 2012-4,Classification and Measurement: Limited Amendments to IFRS 9 (Proposed amendments to IFRS 9-2010).

The proposals aim to provide consistent measurements of different types of financial products, and they’re part of the boards’ response to the 2008 financial crisis.In the wake of the crisis, the standard-setters confirmed that financial instruments had grown increasingly complex, but the accounting methods had not kept pace with them.

Under the proposals, financial instruments would be placed into two main groups—those measured at amortized cost and those measured at fair value.The categorization would depend on the cash flow characteristics of the instruments and the business model of the organization holding them.

Loans that a lender lists on its balance sheet and holds to collect payments of principal and interest would be measured at amortized cost, while assets that are traded would be measured at fair value, with changes recorded in net income.Financial products a business may hold onto but could sell later would fall into a third category: fair value with changes recorded in the section of shareholder equity called other comprehensive income.

Many businesses and auditors, however, told the boards that it was difficult to determine the assets that belonged in each category and said it was especially difficult to understand how to evaluate an organization’s business model.Many also were troubled by what they called the overly strict criteria for the amortized cost bucket.

The boards agreed to clarify that the business model determination would be based upon how the business’s performance is evaluated and reported to management; how managers are compensated; and the frequency, timing, and volume of sales in prior periods. The determination would also assess the reasons for previous sales of the instruments and the expectation that more sales will take place in the future.Businesses should consider all relevant and objective information to make the call, the boards said.

Some respondents to the FASB and IASB’s proposals said the boards seemed to emphasize the volume and frequency of sales in making the business model assessment rather than the reasons for the sales.The boards agreed to clarify that sales don’t drive the business model assessment, and information about sales shouldn’t be considered in isolation.

“What we wanted to do was look at things like business plans, how you compensate people, how you report to management, how you assess performance, and then, as a check, look at how much selling’s going on,” IASB technical director Sue Lloyd said.

A majority of both boards agreed with this move.

“What the staff is doing here is providing us with an opportunity,” FASB member Thomas Linsmeier said.The final standard will focus more on a business’s reasons for either holding an instrument or trading it and not the actual activity.

“I think that’s a huge opportunity to improve current literature,” Linsmeier said.

The boards next addressed how to deal with the accounting for a change in business model, which would force a change in the measurement.Under both boards’ proposals, reclassifications are supposed to be very rare.Critics said the proposals were too strict, and the hurdle to prove that a company had changed its business model was too high.

The boards agreed that they would clarify that a change in business model would occur only when the business has either stopped or started doing something on a level that’s significant to its operations.Generally, this would be the case when the business has acquired or disposed of a business line.

“What we are saying is if you have a change in your business model, you either stop doing something you had been doing in the past, or you start something you haven’t done in the past,” IASB practice fellow Yulia Feygina said. “Generally, that is when you have an acquisition or disposal, but we’re not saying just on acquisition or disposal of a business.We’ve just used this to demonstrate how big that change needs to be.”

The FASB agreed to go with the IASB on the date a reclassification is reported.The U.S. board agreed that the reclassification date would be the first day of the reporting period following the change in business model, as opposed to the FASB’s original plan, which was the last day of the reporting period in which the change occurs.

The boards then addressed the criticism that the criteria were too strict for fitting into the amortized cost category.The boards agreed to include examples of specific activities that are commonly associated with the amortized cost business model and provide guidance on the nature of the information a business should consider in determining whether it qualifies for this treatment.The boards also agreed to emphasize that insignificant or infrequent sales may not be inconsistent with this model.

The last topic focused on the business model assessments of the categories for fair value with changes recorded in other comprehensive income and fair value with changes recorded in net income.

First, the boards affirmed that they wanted this third category, which doesn’t exist in IFRS.Two IASB members—Stephen Cooper and Jan Engstrom—have opposed adding the category throughout the project, and they restated their opposition.The majority of both boards, however, agreed to retain the category and add guidance on how to make the assessment.

“That is, the guidance should make it clear that managing financial assets both to collect contractual cash flows and for sale is the outcome of the way in which financial assets are managed to achieve a particular objective rather than the objective in itself,” according to a staff memo.

While the FASB and IASB agreed to much of the wording presented by their research staffs, the boards are likely to tweak some of the language in the coming days when they release their final summaries of the joint meeting.

The November 20 decisions put the boards on track to complete joint deliberations by the end of the year, the FASB and IASB’s research staffs said.The FASB expects to discuss U.S.-specific issues separately.