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FASB Opts for 'Known Complexity' in Financial Instruments

Tammy Whitehouse | January 7, 2014

The Financial Accounting Standards Board is starting the new year with a bold step away from convergence on financial instruments and impairments.

Before breaking for the holidays, FASB made two key decisions on its project to write new standards for financial instruments that put the board at odds with the direction of the International Accounting Standards Board. FASB decided to abandon an idea heavily criticized in the United States to require a model for classifying debt investments driven by the payment of principal and interest. Instead, FASB will stick with the current guidance that calls for bifurcation, or separation of the elements in hybrid or complex financial instruments. “Although this is a tentative decision, given that it is fundamental to the direction of the project, it seems unlikely that the FASB will revisit it,” wrote PwC in a recent alert.

PwC says the original proposal called for financial assets to be recorded at amortized cost, fair value with earnings recorded in “other comprehensive income,” or fair value with earnings marked to net income. To be eligible for recognition in a way that doesn't impact earnings, an instrument would have to be governed by contractual terms that lead to cash flow solely from the payment of principal and interest.

By retaining the existing guidance, FASB is signaling companies will need to account for derivatives embedded in complex instruments separately if they are not clearly and closely related to the host contract. However, it means the presence of an embedded derivative will not automatically put an instrument into the bucket that hits earnings.

Some FASB members said they were concerned that the proposed model offered no improvements in existing accounting complexity. “It's unfortunate, but people need specificity in terms of how to interpret things,” said FASB member Larry Smith. “I'm not convinced this will significantly, if at all, reduce complexity. A lot of people are saying we're trading known complexity for unknown complexity. It's the unknown that I'm really fearful of.”

On the impairment front, FASB has decided it will proceed with its plan for a credit loss model that takes into account from inception the full lifetime expected losses associated with a particular credit instrument. The board has received mixed feedback on its expected credit loss model, which would require companies to show an expected possible loss on a given instrument when it first hits the books, even if it is fully performing. The IASB model would require companies to begin reflecting possible losses on a given instrument only after there are signs of deterioration of credit worthiness.

Although the Group of Twenty nations have called for the FASB and IASB to reach a converged solution on financial instruments in particular, FASB and IASB have struggled at times to find common ground throughout the project. The two boards are committed to working together to complete their core convergence projects, but FASB has made clear its plan to chart its own course going forward, pursuing improvements to U.S. rules as a priority over convergence to international rules.