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GAAP’s Measurements for Financial Instruments May not Match Up with IFRS

December 23, 2013

The FASB was close to writing a standard that would match the IASB’s guidance for classifying and measuring financial instruments, but the U.S. board’s latest decision makes that outcome unlikely.The FASB rejected a key piece of its planned model and intends to explore developing a new cash-flow characteristics test.

Saying a key piece of the joint classification and measurement model it was developing with the IASB was too complicated to work, the FASB on December 18, 2013, abandoned this part of the project and took steps to develop something new.

The decision was part of the board’s effort to complete what once was a global effort to promote consistent measurement of increasingly sophisticated financial assets and liabilities—a top priority in the wake of the 2008 financial crisis.If the FASB finalizes its December 18 decision, however, it is unlikely a worldwide accounting standard will come to fruition.

“I don’t think there’s any real chance of convergence right now,” said Adam Brown, national assurance partner at BDO LLP.

The FASB’s main stumbling block with the joint classification and measurement effort was the very problem the project sought to combat: Complexity.

The proposal grouped financial instruments into three measurement categories—amortized cost, fair value with changes recorded in net income, and fair value with changes recorded in other comprehensive income.Instruments are assigned to categories based upon their cash-flow characteristics and the business model they serve.The December 18 decision dealt with the cash-flow characteristics test.

The test sounds simple, but banks and auditors told the FASB that the test would be impossible to implement in real life, given the way it’s described in Proposed Accounting Standards Update (ASU) No. 2013-220,Financial Instruments—Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities.

Banks were especially frustrated by the requirements to qualify for classifying a loan at amortized cost.Under the joint model, only assets that consist of “solely payments of principal and interest” would qualify for this accounting treatment. This could lead to more loans accounted for at fair value, they said.

“Something that’s solely payments of principal and interest sounds very nice and pure,” said Michael Gullette, vice president for accounting and financial management at the American Bankers Association.Many loans are more complicated. He gave an example of an adjustable rate loan with a rate based on the one-year London Interbank Offered Rate (LIBOR).The arrangement poses the risk that the loan and the liabilities used to fund it could reprice at different rates based upon market conditions.

The risk that the price changes wouldn’t offset one another means that the loans wouldn’t qualify for amortized cost measurement, he said.

“You had to go into what ‘solely’ meant, what ‘principal’ meant, what ‘interest’ meant, and then it became a mess,” Gullette said.

The FASB and IASB sought to alleviate the concerns by revising some of the definitions in the cash-flow characteristics test to let more loans qualify for amortized cost treatment.The effort resulted in extra work for businesses to figure out how to account for financial instruments, FASB members said.

“I’m not convinced we’ve significantly, if at all, reduced complexity,” FASB member Lawrence Smith said. “A lot of people say we’re trading known complexity for unknown complexity.It’s the unknown I’m really fearful of.”

The FASB also could not justify a new, complex model by saying it would improve financial statement understandability for investors and analysts, said FASB member Harold Shcroeder, a former analyst.

“I was very enticed by the two-step business model and cash flow characteristics model test,” Schroeder said. “But as we’ve progressed and you’ve showed us the flow chart and decision trees, I’m more and more accepting of the reality that we didn’t fix the preparer problem and we haven’t fixed the user problem of not understanding and making it understandable for them.I’m left with the decision that I can’t justify, from a cost standpoint, making the changes.”

After the board decided to abandon the cash-flow characteristics test in the joint model, which was also outlined in the IASB’s November Exposure Draft, (ED) No. 2012-4,Classification and Measurement: Limited Amendments to IFRS 9 (Proposed amendments to IFRS 9-2010),the FASB decided to retain existing U.S. GAAP for financial instruments with embedded derivatives, such as convertible bonds.

This decision was related to whether to separately measure, or bifurcate, the derivative from the host contract.Current U.S. GAAP allows bifurcation, and a majority of the FASB agreed to maintain this practice.

The FASB has to decide how to proceed with the cash-flow characteristics test.The board directed its staff to come back later with an analysis of potential new tests.

The IASB is close to finalizing its version of the project, so aligning with the international board seems like a dim prospect.

However, although the accounting may be different on either side of the Atlantic, but the outcome ultimately may be similar, said Grant Thornton LLP managing director Jamie Mayer.

“If I’m a U.S. company, the way I go about evaluating is different than the IASB, but the end game may be the same,” Mayer said.

Having two different accounting regimes would still cause headaches for some international banks, he said.

“If I’m a bank and my parent is in London but I have separate reporting obligations in the U.S. because I have to file a call report or something, I’m going to have to go through a different process,” Mayer said. “International banks are going to be the more affected entities.”