Accounting for Financial Instruments

WHAT ARE FINANCIAL INSTRUMENTS?

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:
  • Credit Losses (Impairment)
  • Recognition 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. 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 will replace the multiple impairment models that currently exist for debt instruments in 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, when combined with the reported balance of the debt instrument, would reflect management’s estimate of the cash flows it expects to collect, based on its assessment of credit risk as of the reporting date. The FASB has completed its major decisions in this area, and expects to issue a final standard in mid-2016.

Public businesses that meet the definition of an SEC filer will be required to apply the guidance for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.

Other public business entities will be required to apply the guidance for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years.

Entities that are not public business entities—including private companies, not-for-profit organizations, and employee benefit plans within the scope of FASB guidance on plan accounting—will be required to apply the guidance for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.

Early application of the guidance will be permitted for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.

The Transition Resource Group for Credit Losses (TRG) looks at potential implementation issues.


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RECOGNITION & MEASUREMENT

On January 5, 2016 the FASB issued an Accounting Standards Update (ASU) intended to improve the recognition and measurement of financial instruments. The ASU affects public and private companies, not-for-profit organizations, and employee benefit plans that hold financial assets or owe financial liabilities.

The new standard is intended to provide users of financial statements with more useful information on the recognition, measurement, presentation, and disclosure of financial instruments,” stated FASB Chairman Russell G. Golden. “It improves the accounting model to better meet the requirements of today’s complex economic environment.

The new guidance makes targeted improvements to existing GAAP by:
  • Requiring equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income
  • Requiring public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes
  • Requiring separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements
  • Eliminating the requirement to disclose the fair value of financial instruments measured at amortized cost for organizations that are not public business entities
  • Eliminating the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet, and
  • Requiring a reporting organization to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk (also referred to as “own credit”) when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments.
The ASU on recognition and measurement will take effect for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. For private companies, not-for-profit organizations, and employee benefit plans, the standard becomes effective for fiscal years beginning after December 15, 2018, and for interim periods within fiscal years beginning after December 15, 2019. The ASU permits early adoption of the own credit provision. Additionally, it permits early adoption of the provision that exempts private companies and not-for-profit organizations from having to disclose fair value information about financial instruments measured at amortized cost.

More information on the ASU can be found within a high-level FASB in Focus overview.

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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 reported (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.

The FASB’s project on hedging addresses issues related to hedge accounting for financial instruments and non-financial items. The objective of this project is to make targeted improvements to the hedge accounting model based on the feedback received from preparers, auditors, users and other stakeholders. The Board also will consider opportunities to align hedge accounting guidance in GAAP with IFRS 9, Financial Instruments.

The staff is developing a draft proposed Accounting Standards Update based on the tentative decisions reached by the Board. Later in the drafting process, the Board will discuss any additional issues that arise during drafting, the benefits and cost of the proposed Accounting Standards Update, transition, and comment period.


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