Accounting for financial instruments – including everything from traditional bank loans to exotic hybrid securities and derivatives – was in the spotlight this week as both U.S. and international standard setters announced changes in how companies would have to account for them.
Each group is nearing completion of the first of the three phases of a project that comprises recognition and measurement, loan-loss provisioning, and hedge accounting. But differences still exist between the two sets of proposed rules. Some of those will be ironed out next week when the International Accounting Standards Board travels to Norwalk, Connecticut, for a three-day joint meeting with the Financial Accounting Standards Board. The meeting is one of many the two boards have had since 2002, when they agreed to work together to issue a single set of global accounting standards.
The decisions made this week will frame some of next week’s agenda. On Wednesday, FASB members reached consensus on how companies should account for bad debt, also referred to as credit impairments, for example. The category includes the losses banks and financial institutions incur when loans or other debt obligations they hold are not paid on time.
The FASB staff is still working on the exact language that eventually will be become part of a draft rule it will release for public comment. Nevertheless, the board made clear that the revised standard will use a current-loss model, which is a departure from IASB’s IAS 39 which calls for an expected-loss model.
The current-loss model requires financial institutions to measure their credit losses at the end of a period by determining the decrease in the net present value of the company’s future cash flows. The estimate, says FASB, should be based on known factors, including historic and existing conditions that could impair the creditor’s ability to pay back its obligation in a timely way.
Companies should consider, for example, remaining-payment terms, the financial condition of the creditor, and expected defaults. They should also look at such broader environmental factors as the industry, geographic region, economy, and political sphere within which the creditor operates. (FASB also noted that it would consider how interest income will be recognized at a future meeting.)
IASB, in its version of the credit-impairment provision, requires financial institutions to use the expected-loss model to make ongoing assessments of existing and potential bad debt. Banks would be asked to monitor “triggering” events and recognize potential bad debt earlier than FASB’s rule would require. An example of a triggering event for a bank could be a massive layoff at an auto manufacturer that portends a significant drop in revenues at an auto-parts maker, thereby increasing the risk that the parts maker will default on the bank’s loan.
The expected-loss model was recommended by the G20 leaders and others in light of the global financial crisis. Proponents of the model say the subprime mortgage crisis could have been considered a triggering event that, under the expected-loss model, would have forced banks to recognize projected credit losses earlier. That early-warning system, in theory, would have stopped banks from lending too much because their balance-sheet cash reserves would have been dangerously low in regulatory capital.