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Plan to Fix Accounting for Liability Risk Moves Ahead

April 25, 2014

The FASB is continuing to make progress with its planned improvements to the classification and measurement of financial instruments. The board decided that businesses will present in other comprehensive income changes to their liability risk, which was a controversial issue during the financial crisis. The board also confirmed that it wanted to keep most of current U.S. GAAP’s fair value option intact.

The FASB on April 23, 2014, addressed a problem with the way businesses account for changes in the value of outstanding debt during market downturns.

The issue became a controversial one during the financial crisis, as some companies saw demand for their bonds drop and the bonds’ market value decrease. The shift allowed the companies to write down the value of some liabilities and book a gain from an accounting change at a time when investors saw them as financially compromised because of their exposure to the housing market.

For financial liabilities measured at fair value with changes recorded in net income, the FASB said the portion of the change due to instrument-specific credit risk should be presented in other comprehensive income. This largely affirmed what the board published in the February 2013 Proposed Accounting Standards Update (ASU) No. 2013-220, Financial Instruments—Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities, which set out to overhaul the accounting for increasingly complex financial assets and liabilities.

Board members agreed to the presentation question relatively quickly, but they had a harder time defining what “instrument-specific credit risk” meant. They also struggled with how businesses should separate instrument-specific credit risk from the total fair value changes of such financial liabilities, which the FASB calls an entity’s “own credit.”

FASB member Thomas Linsmeier spoke at length against a bigger-picture problem affecting the liability risk issue—allowing businesses more options to measure their liabilities at fair value.

“I’d understand some of that if we could actually measure changes in the value of own credit,” Linsmeier said. “Instead we’re providing a fair value option for liabilities, telling people that they have to measure it and then way over-measure it, and make it look far bigger than it is, making us look stupid for even letting them do fair value.”

In the end, a majority of the board agreed that a business may consider the portion of the total change in fair value that exceeds the amount resulting from a change in a base market risk, such as a risk-free interest rate, to be the result of a change in instrument-specific credit risk. A business could also choose another method that “faithfully” represents the total change.

The FASB also reaffirmed a tentative decision it made on April 4 to keep U.S. GAAP’s so-called fair value option, which allows many financial instruments to be measured at fair value. The decision rejected a change from Proposed ASU No. 2013-220 that would have narrowed the types of financial assets and liabilities a business could choose to measure at fair value.

The proposal eliminated the unconditional fair value option in U.S. GAAP. It narrowed down the instruments allowed to take the fair value option to groups of assets and liabilities whose net exposure is managed on a fair value basis and whose information is reported to management on a net exposure basis; hybrid financial instruments that contain an embedded derivative; financial assets that may be held to collect payments or may also be sold; and nonfinancial hybrid liabilities that contain an embedded derivative.

Many investors and analysts applauded the reduction of instruments that could take the option to be measured at fair value—and some supported eliminating the option entirely. Reducing or eliminating the option would enhance their ability to compare businesses more easily, they said. But businesses said they wanted to retain the option.

Linsmeier again spoke out against the option.

“I think we’re creating our own problem [by] over-measuring things,” Linsmeier said. “Without the fair value option, we don’t have that problem, and then you’d bifurcate derivatives if they’re bifurcated and treat derivatives the same.”

The FASB’s classification and measurement proposal stems from extensive work with the IASB, which issued a related proposal in November 2012 in Exposure Draft (ED) No. 2012-4, Classification and Measurement: Limited Amendments to IFRS 9 (Proposed amendments to IFRS 9-2010).

The boards initially agreed on their planned changes to the accounting for financial instruments, but discussions broke down late in 2013 when the FASB said the joint model was too complex to justify major changes to U.S. GAAP.

The FASB instead has been focusing on narrower changes to current accounting rather than a wholesale revamp of U.S. GAAP.

The joint FASB and IASB classification and measurement project was once the crux of the standard-setters’ overhaul of the accounting for financial instruments. The boards had sought to create a single, global way to promote consistent measurement of increasingly sophisticated financial assets and liabilities.

A global standard had been a priority in the wake of the 2008 financial crisis, but it became an elusive goal as the FASB and IASB wrestled with tough questions from banks, auditors, and analysts.

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