IASB/FASB Financial Instruments Projects

Background

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) have issued exposure drafts regarding the accounting for financial instruments.  While dubbed "financial instruments" projects, these projects are really about bank accounting and represent the biggest overhaul of accounting principles ever. 

In summary, there are three main issues:

1. Classification and measurement: What assets and liabilities should be measured at amortized cost (with an allowance for losses) and what should be measured at fair value?
   
   
2. Impairment: For those assets measured at amortized cost, how should the allowance for losses be measured?
   
   
3. Hedge accounting: for derivatives that are used in hedges, what requirements and accounting entries should there be?

Within each of these phases, footnote disclosure, as well as financial statement presentation issues, is addressed.

Though they maintain a commitment to converge accounting standards, the IASB and FASB are working on two different paths, with the IASB already issuing a final standard for classification and measurement, and an exposure draft for impairment.  FASB has issued one large exposure draft addressing each of the three phases.  Both the IASB and FASB projects are expected to be completed, with final rules issued by the end of 2011.  The effective dates for each phase are expected to be no earlier than 2011. 

Key Assessment Points of the Different Proposals

1. Because of convergence plans, IASB decisions are expected to highly influence a converged standard.
   
   
2. FASB classification and measurement expands mark-to-market accounting by requiring all loans and unfunded loan commitments and deposits.
   
   
   1. A core deposit intangible will now be recorded and maintained
   2. A requirement to present one the statement of comprehensive income will effectively change the "bottom line" to net comprehensive income that includes what would be reported in Other Comprehensive Income.

June 2011 Update: 

Based on preliminaray decisions by the FASB (they are subject to change): 

1. Loans will not be required to be marked to market:  Loans and Debt securities that are part of a "customer financing activity" will be recorded at amortized cost (less impairment).
    
2. Debt securities not part of a "customer financing activity" are recorded either at fair value, with changes running through other comprehensive income (those held for liquidity purposes)or fair value, with changes running through net income (those held for trading).  There will no longer be a Held-to-maturity designation.
   
   
3. There will be no reclassification or tainting of portfolios based on sales.
   
   
4. Financial liabilities (including deposits) will be recorded at amortized cost, unless the company manages based on fair values and is able to satisfy the obligation at fair value.
   
   
5. Other comprehensive income will not be required to be shown on the same performance statement as the traditional income statement.
   
   
6. Unlike that in IFRS 9 (described below), there will continue to be bifurcation of embedded derivatives for hybrid securities (assets and liabilities).

Analysis:  It is very favorable that FASB has backed off the effort to require mark to market accounting.  Further, FASB's decision to retain bifurcation of hybrid securities will avoid problems that IFRS 9 introduces (see below in point 3d). However, because there will be no held-to-maturity classification, there will still be more mark to market.  There are very legitimate reasons for banks to hold securities to maturity and we will continue to advocate to retain this classification.

    3.  As finalized in IFRS 9, IASB classification and measurement appears
         reasonable on paper, but implementation by auditors and examiners may
         be  problematic. Though not designed to, the IASB model may result in
         more mark-to-market accounting for some banks.

  a.  Loans and debt securities that are held for investment are  generally
       recorded at amortized cost.

  b.  Tranches of structured securities that are rated lower than the
       weighted average of the total pool automatically are recorded at fair 
       value, with changes in fair value running through earnings.

  c.  Banks must be able to "look through" to underlying assets of a
       structured security in order to avoid recording them at fair value.

  d.  There is no "bifurcation" of embedded derivatives, so many related
       securities may end up with mark-to-market accounting.

     4.   IASB method to estimate loan losses is operational by tougher than 
         FASB's

  a.  IASB method requires a "through the life of the asset" estimate of 
       the present value of cash flows.

            b.  FASB method appears to merely take off the "probable" and
                "estimable" triggers and merely asks "What do you think you will lose, 
                 based on current conditions?"

June 2011 Update on Impairment: 

IASB and FASB issued a supplemental document (SD) requesting comments on an impairment model for loans that works as follows:

    a.  Impairment on loans identified as being in a "bad book" is 
         measured at the expected loss.

    b.  Impairment on loans identified as being in a "good book" is 
         measured at the greater of:

i.  The expected losses in the foreseeable future (FF method) or 
ii.  A time-proportionate allocation of expected losses over the life
    of  the portfolio (TPA method).

   c.  Triggers that have been historically used to identify a probably loss
        (under an incurred loss methodology) are eliminated.

   d.  All information, including supportable forecasts of the future, may be 
       used in the assessment.

Analysis:  None of the respondents to the SD model liked it.  U.S. investors, banks, and the FASB preferred the FF method without the TPA and the rest of the world seemed to prefer the TPA without the FF method.  Most U.S. banks, however, prefer a model that, instead of creating totally new systems, builds on the current model, yet provides for supportable allowances that forecast losses that may not be apparent through standard bank metric analysis.  This model responds to concerns related to "too little, too late" by providing for losses that may be masked due to an expanding business cycle or unclear through a new product offering.  See the ABA comment letter that refers to this U.S. Banking Industry model.   See the paper of the U.S. banking industry model that addresses IASB concerns that interest income in the impairment model should match the losses.

Impairment is a key area of the convergence of International Financial Reporting Standards with U.S. GAAP, if that will take place.

A model is currently under consideration by both FASB and IASB that is expected to result in an exposure draft by the end of 2011.  The model is expected to classify loans and securities into different "buckets", based on the asset's credit risk.  Such classification will determine the impairment measure to be used. 

   5. Because of their concern for the reliability of fair values of loans, FASB has
       proposed a four year deferral for privately held banks under $1 billion in 
       assets. This doesn't make sense. If no one currently understands the fair 
       values of loans, it is obvious that no one – investors, regulators, depositors, 
       bank management – believes they are relevant. Reliability and relevance 
       are the two primary qualities that make financial information useful for 
       decision making (per FASB's own Concept Statement No. 2). FASB is 
       "breaking its own rules" in trying to apply fair values to loans.

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Questions? Please contact Mike Gullette, Vice President, Accounting and Financial Management.