Board Meeting Handout. Accounting for Financial Instruments: Classification and Measurement January 21, 2011

Transcription

1 Board Meeting Handout Accounting for Financial Instruments: Classification and Measurement January 21, 2011 PURPOSE OF THE MEETING 1. At the December 21, 2010, Board meeting, the Board decided to consider amortized cost as an alternative primary measurement attribute for certain financial assets. The Board also reaffirmed its decision in the proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, that both the characteristics of a financial asset and an entity s business strategy for a financial asset should be used as criteria to determine the classification and measurement of a financial asset. In addition, the Board asked the staff to consider whether a notion of market activity for a financial asset could be incorporated into the business strategy criterion for classification and measurement purposes such that an entity would consider the marketability of a financial asset if it asserts that it is holding the financial instrument for the collection of contractual cash flows. Also at that meeting, the Board directed the staff to develop complete classification and measurement models for financial assets that encompass a three category approach focusing on (a) the characteristics of the instrument and (b) the entity s business strategy. 2. This meeting s purpose is to discuss the following issues: a. Issue 1: Business Strategy Approaches b. Issue 2: Reclassification of Financial Instruments between Categories c. Issue 3: Tainting d. Issue 4: Recycling of Fair Value Changes Recognized in Other Comprehensive Income (OCI). The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

2 3. The characteristics criterion used in the classification and measurement model will not be discussed at this meeting. However, the classification and measurement model would be structured in a format similar to the proposed Update in which financial instruments with certain characteristics would not qualify to be evaluated within the business strategy criterion and, therefore, would be classified as Fair Value Net Income (FV-NI) by default. Consequently, the measurement categories of Fair Value Other Comprehensive Income (FV-OCI) and amortized cost would be available only to simpler, plain vanilla instrument types. ISSUE 1: BUSINESS STRATEGY APPROACHES FOR FINANCIAL ASSET CLASSIFICATION 4. The staff developed two alternative business strategy approaches that would require three classification and measurement categories. The business activity and value realization approaches would result in the same general classification criteria for the FV-NI and FV-OCI categories. However, the application of the two alternative approaches differs for the amortized cost category. Business Strategy Categories Fair Value Net Income (FV-NI) 5. The FV-NI category would be the same under both approaches and would encompass an entity s trading or held-for-sale activities. Those activities would include (a) issuing or purchasing financial assets that are bought and sold for shortterm profit taking, (b) managing an inventory of trading assets to support the demands and needs of clients that wish to make investment purchases, and (c) loans held for sale in the near future. Fair Value Other Comprehensive Income (FV-OCI) 6. The primary purposes of an entity s investing activities are to manage and invest the excess capital and, simultaneously, maximize returns on the related financial assets. Those functions provide investment opportunities while managing the entity s 2

3 exposure to market shifts, economic cycles, interest rate risk, and liquidity or capital adequacy concerns. Under both approaches, financial assets that are being managed in accordance with an investing activity or that are being used to manage the interest or liquidity risk of an entity would be measured at fair value with qualifying changes in fair value recognized in OCI. Amortized Cost Alternatives Approach 1: Business Activity Approach 7. The first approach for measuring and classifying financial assets at amortized cost is based on the business activities that an entity employs in acquiring and managing financial assets. Approach 1 is principally based on the primary business activities that typically exist in many large, diversified financial institutions that include trading, investing, and lending activities. 8. Under Approach 1, the amortized cost category would contain debt instruments that are generated through a lending activity. The purpose of an entity s lending activities is to provide competitive sources of funding to meet the financing needs of customers and generate income on the fees and interest charged to those customers. In some instances, lending activities naturally incorporate the notion of a relationship with the customer and the intention of managing that relationship over a long period of time. Lending activities do not include portfolios held as inventory to be sold to satisfy a client s demand or an entity s capital needs but,rather, are held to earn a return on the initial outlay of cash through the return of principal plus interest over the effective life of the loan. Approach 2: Value Realization Approach 9. The second business strategy approach for amortized cost is based on the manner in which an entity intends to realize the value from the financial assets that it holds. Approach 2 focuses on the method of realization of value changes, which may not be necessarily in accordance with the activities or structure of the business as described in Approach 1. The amortized cost category would include financial assets in which an entity has both the intent and ability to hold the instrument for the collection of the contractual cash flows throughout substantially all of the asset s 3

4 effective life. That is, the amortized cost category would include financial assets in which an entity s strategy would be to collect all of the contractual cash flows related to the financial asset rather than to sell the financial asset to a third party, regardless of the business activity from which the asset originated, was acquired, or is currently being managed. 10. Approach 2 focuses on the intended method of value realization for financial assets and utilizes the notion of marketability to determine the likelihood of an entity achieving those initial strategies. To assist in determining the value realization strategy of an entity and the relevance of fair value information for a particular asset, there would be a rebuttable presumption that the entity does not intend to hold the instrument for the collection of cash flows for substantially all of its life if the instrument is marketable. The entity may overcome the rebuttable presumption if it can demonstrate that it has the intent and ability to hold the instrument for collection of cash flows. Question 1 for the Board Which business strategy approach does the Board think should be used to classify and measure financial assets? If the Board does not support either approach, how would the Board develop the business strategy criterion to allow for three categories? ISSUE 2: RECLASSIFICATIONS Constituent Feedback 11. Most users noted that they agree with the guidance on reclassifications in the proposed Update, which does not support reclassifications based on changes in an entity s business strategy. Nonusers who also do not support reclassifications state that allowing reclassifications will reduce comparability and consistency between reporting periods and among entities. 4

5 12. However, most nonusers who support using an entity s business strategy as a primary criterion for the classification and measurement of all financial instruments generally support allowing for reclassifications as an entity s business strategy develops or changes over time. Constituents who support this view say that there is no strong technical argument for prohibiting reclassifications. They note that although it may occur infrequently, it seems that reclassifications should be permitted when an entity changes its business strategy. Additionally, some constituents note that requiring newly acquired or issued financial instruments to be classified based on the new business strategy while continuing to classify existing financial instruments based on the prior strategy seems contradictory. That is, both the newly acquired/issued and existing financial instruments are subject to the same (changed) business model, yet they are classified differently. 13. Many of the constituents who support reclassifications also agree that there should be increased transparency and disclosures about reclassifications if they are permitted and allowed to occur. For example, those constituents agree that disclosures about the reason for the reclassification as well as information that describes the effect of the reclassification on the entity s financial statements should be required. Alternatives 14. As part of the decision to introduce an amortized cost category, if an entity s business strategy or intent for an individual financial asset or group of financial assets changes, the Board will need to decide whether an entity should be permitted to sell directly out of an amortized cost category or whether transfers out of the heldfor-sale category into another category should be required before a sale. 15. If the Board decides to reconsider its previous decision that reclassifications should be precluded, various approaches could be considered, including the following: a. Alternative 1: Reclassifications between all categories (similar to IFRS 9, Financial Instruments) 5

6 b. Alternative 2: Reclassifications only between certain categories (if the Board decides to permit an amortized cost measurement category). 16. If the Board decides to allow one of the above alternatives, consideration about whether reclassifications would be accounted for retrospectively or prospectively also would be needed. Question 2 for the Board Does the Board support permitting reclassification of financial assets? If so, which reclassification alternative does the Board think should be used to reclassify financial assets? ISSUE 3: TAINTING 17. Nearly all constituents who support reclassifications encouraged the Board to provide detailed guidance on portfolio turnover and tainting implications to avoid confusion and diversity in practice. 18. If the Board decides to permit certain financial assets to be measured at amortized cost and reconsiders its previous decision that reclassifications would be precluded, the staff has identified the following three alternatives for the Board s consideration to resolve any tainting issues: a. Alternative 1: If the intent regarding the business strategy changes (regardless of the reason), subsequent sales or reclassifications of financial assets initially classified as held for collection of contractual cash flows would not taint an entity s amortized cost portfolio. b. Alternative 2: Only sales or transfers due to certain changes in circumstances or other events would not taint an entity s amortized cost portfolio. That is, similar to the guidance on investments debt and equity securities in Section of the FASB Accounting Standards Codification, the sale or transfer of a financial asset classified as held for collection would not call into 6

7 question its original classification if the change in business strategy is due to circumstances or other events that are isolated, nonrecurring, and unusual for the reporting entity and could not have been reasonably anticipated. c. Alternative 3: Subsequent sales or transfers of financial assets initially classified as amortized cost would not taint the classification of an entity s held for collection portfolio if those sales are infrequent and insignificant relative to a financial asset class that is classified as held for collection. Question 3 for the Board Does the Board support a notion of tainting for the classification and measurement model? If so, which alternative for tainting does the Board think should be used to evaluate the classification of financial assets? ISSUE 4: RECYCLING OF FAIR VALUE CHANGES 19. The proposed Update would require that changes in fair value that have been recognized in OCI should be recognized in net income (or recycled) when such gains or losses are realized from sales and settlements. Conversely, IFRS 9 permits an entity to make an irrevocable election to present in OCI changes in the value of an investment in equity instruments that is not held for trading. Those amounts presented in OCI are not subsequently recognized in net income when the equity instruments are derecognized (for example, sold). 20. During the comment period phase of IFRS 9, many respondents, including most users, stated that they do not support the proposal to prohibit recycling of fair value changes to net income on derecognition of the investments in an equity instrument. Rather, most respondents stated that they support an approach that maintains a distinction between realized and unrealized gains and losses and would prefer that an entity s net income include all realized gains and losses. 7

8 Question 4 for the Board Does the Board support retaining the guidance for recycling of fair value changes recognized in OCI into net income? 8