Accounting for Financial Instruments

WHAT ARE FINANCIAL INSTRUMENTS?

U.S. Generally Accepted Accounting Principles (GAAP) defines a financial instrument as cash, evidence of an ownership interest in a company or other entity, or a contract that does both of the following:
  1. Imposes on one entity a contractual obligation either:
    1. To deliver cash or another financial instrument to a second entity
    2. To exchange other financial instruments on potentially unfavorable terms with the second entity.
  2. Conveys to that second entity a contractual right either:
    1. To receive cash or another financial instrument from the first entity
    2. To exchange other financial instruments on potentially favorable terms with the first entity.
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A BRIEF HISTORY OF THE ACCOUNTING FOR FINANCIAL INSTRUMENTS PROJECT

Since 2005, the FASB and the International Accounting Standards Board (IASB) have been working together to improve and simplify reporting for financial instruments. The main objective, then and now, has been to provide financial statement users with a more timely and representative depiction of a company, institution, or nonpublic not-for-profit organization’s involvement in financial instruments, while reducing the complexity in accounting for those instruments.

Over time, the FASB and the IASB took different approaches to various aspects of the accounting for financial instruments. In 2009, the IASB issued IFRS 9, Financial Instruments, which provides guidance on classification and measurement of financial assets. Meanwhile, in May 2010, the FASB issued its proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. The feedback received on that Exposure Draft caused the FASB to rethink its original proposals on these issues, and to approach the project in three separate phases:
  • Impairment
  • Classification and Measurement
  • Hedging
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CREDIT LOSSES

The global financial crisis of 2008 highlighted the need for more timely financial reporting of credit losses on loans and other financial instruments held by banks, lending institutions, and public and private organizations. U.S. GAAP currently accounts for credit impairment using an “incurred loss” model. Because the existing impairment model delays recognition of the credit loss until the loss is probable (or has been incurred), many have argued that the model fails to alert investors to expected credit losses in a timely manner. Some have recommended that standard setters explore alternatives to the incurred loss model that would use more forward-looking information.

In December 2012, the FASB issued its proposed Accounting Standards Update which sets forth a “current expected credit loss” (CECL) model. This proposed model would replace the multiple impairment models that currently exist for debt instruments in U.S. GAAP. The CECL model uses a single “expected credit loss” measurement objective for the allowance for credit loss. Under this model, the allowance for expected credit losses would reflect management's current estimate of the contractual cash flows that the company does not expect to collect, based on its assessment of credit risk as of the reporting date. Upon conclusion of the April 30, 2013 comment period, the Board expects to begin outreach with stakeholders, and will carefully consider comments received on this and on the IASB’s recent (March 2013) proposal prior to finalizing a standard.



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CLASSIFICATION & MEASUREMENT

As part of its financial instruments project, the FASB also is working to improve how financial instruments are classified and measured. This includes simplifying the multitude of classification methods currently in use.

In February 2013, the FASB issued its proposed accounting standard that would measure financial assets based on how a reporting entity would realize value from them as part of distinct business activities. The measurement of financial liabilities would be consistent with how the entity expects to settle those liabilities. The FASB’s proposal provides opportunities for convergence with the IASB’s proposal, issued in November 2012.

The Exposure Draft also would narrow the availability of the existing fair value option for financial assets and financial liabilities. In those limited cases where the fair value option would be allowed for financial liabilities, changes in the fair value attributable to an organization’s own credit risk would be reported in other comprehensive income (OCI), rather than net income.

The comment deadline ends on May 15, 2013. The FASB then will engage in outreach with stakeholders prior to finalizing a standard.



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HEDGE ACCOUNTING

Many companies use derivative financial instruments to hedge their exposure to certain risks. Today, hedge accounting is an elective approach that minimizes the accounting volatility created when derivatives, which are otherwise accounted for at fair value through net income, are used to hedge revenue or expenses that are not yet recognized at all (e.g., forecasted sales or purchases) or to hedge assets or liabilities that are not measured at fair value through net income (e.g., inventory or debt). Qualifying criteria must be met in order to apply hedge accounting.

Both the IASB and the FASB have proposed changes to their respective hedge accounting models to address the complexity and improve the understandability of the current financial reporting of hedging activities. The FASB’s proposals were contained in its 2010 Exposure Draft. Now that the FASB has issued its proposals on impairment and classification and measurement of financial instruments, it will resume its deliberations on hedging sometime during the 2nd half of 2013.


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