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.
The other big difference between the U.S. GAAP and international financial reporting standard involving financial instruments is the way changes in fair value are recognized on the face of company financials. The standards begin in the same place, since both rules divide financial instruments into two categories: instruments that management intends to trade or sell in the short-term and non-traded instruments. The latter are those held until maturity under a contractual obligation, such as a loan agreement.
Both rules call for companies to book loans on their balance sheets and record calculated credit impairments on their income statements. Also, the boards allow companies to book the loans at amortized, or historical, costs if the instruments are plain-vanilla loans and the company’s business strategy is to hold them, rather than trade or sell them.
In the case of U.S. generally accepted accounting principles, however, FASB requires companies to break out residual fair value – the change in fair value as compared to its transaction price – and record it as other comprehensive income. In contrast, under IFRS, the full fair value remains above the net income line as part of the credit-impairment number.
Consider a simple example: a $10,000 traditional bank loan issued with a fixed interest rate. All things being equal, let’s say that under U.S. GAAP, a bank calculates that it has $1000 worth of bad debt running through its income statement and posts its estimate of the loan’s fair value to be $8,500 on its balance sheet. The remaining $500, which is the residual fair value, drops to OCI.
As a result, companies using U.S. GAAP and booking loans at amortized costs will present two bottom lines on their income statement, with the OCI line reflecting changes in fair value. The idea is that swings in fair value related to financial instruments would be recorded in one place and would be monitored more easily by financial statement users than has been the case in the past.
Under the old FAS 130, companies weren’t required to present the double bottom line on the face of the financials, only to disclose changes in fair value in the footnotes. In fact, OCI was often relegated to “changes to shareholder’s equity” and considered separately from net income. In response to calls for more transparency, FASB has assigned new prominence to OCI that should help investors, as well as potential buyers, track the effect of fair-value changes on total comprehensive income, which includes net income and OCI.
Earlier this week, IASB Chairman David Tweedie announced to a group of European finance ministers that the first phase of the board’s financial instrument rules would be ready by November. “The final standard will likely result in financial institutions that undertake traditional banking activities of raising deposits and making basic loans applying less fair-value accounting rather than more,” asserted Tweedie. Indeed, with the new rule, IASB is introducing a risk-weighted use of fair value, in that the more risk inherent in the financial instrument, the more likely a bank will be required to use fair-value accounting to record changes in the instrument’s worth.
FASB’s proposed rule on classification and measurement will likely be released for public comment early next year, if not sooner.