The purpose of this paper is to discuss and summarize guidance provided by both the IASB and FASB for accounting for financial instruments. The primary discussion will be directed toward the current differences between the two set of standards with a focus on classification of debt and equity securities. Also the following paragraphs will provide a broader overview of the recent efforts underway for convergence of accounting for financial instruments in alignment with the 2002 Memorandum of Understanding under "The Norwalk Agreement". Also discussed in some detail is the fair value mark-to-market debate which is pivotal in any discussion of the future of accounting for financial instruments. As will be discussed mark-to-market accounting may make obsolete the need to categorize financial instruments in any manner similar to the topic of this paper.
The nature of financial instruments makes accounting for related transactions complex. As a result of the recent and seemingly receding financial crisis this topic has generated a high magnitude of attention from media, politicians, academics, and accounting authorities including the SEC, FASB, and the IASB to name the most influential. The goal stated by of both FASB and IASB is to simplify the accounting as much as possible to provide more consistency, transparency and make resulting information easier to understand for those who utilize financial statements.
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The topic can be primarily deconstructed into two main components. One is most relevant to the balance sheet perspective of accounting and the other to the income statement. Valuation is the topic related to the balance sheet and recognition (or derocognition) the subject matter related to the income statement. Each of these components can be broken down even further into initial recognition and valuation and subsequent valuation and recognition of the change in carrying value.
Both FASB and IASB have adopted what is know n as the "mixed attributes" model for determining how changes in value should be recognized for different financial instruments. Using this mixed attributes model under different circumstances many methods exist for valuing for financial reporting purposes both financial assets and financial liabilities mainly depending on management's underlying stated purpose for holding such financial instruments (Although IASB seems to be moving away from this identification method). (Testimony of Kevin J Bailey) Inconsistencies resulting from multiple valuation methods come at the expense of comparability and relevance. Under this model the same instrument held by one organization can be valued differently. "A long-term solution to address such measurement-related problems is to measure in the same way all types of financial instruments within the scope of a standard for financial instruments. Fair value seems to be the only measure that is appropriate for all types of financial instruments." (Invitation to Comment, Reducing Complexity)
This apparent shift towards fair value accounting has encountered an increase in momentum in recent years. The shift towards the long term goal of a single mark-to-market valuation approach for all assets is apparent in the guidance provided in SFAS115, SFAS 157, SFAS 159 and SFAS 133 by the FASB and the release of IAS 39 IAS 32 and most recently the IFRS exposure draft by the IASB of IFRS 9. The most notable of the shift is provided in SFAS 159 which provides a fair value reporting option for many assets and liabilities for which this option was not available before.
As motioned previously the boards have each expressed a common vision of utilizing fair value in the long term as a single common reporting measurement for financial instruments. Although this goal would appear to indicate the boards are in lock step the fact that each board maintains a separate definition of fair value demonstrates more convergence work may be necessary than it initially appears. The long term goal of a single measurement method for all financial instruments has had no precise time line agreed upon by the boards. Many intermediaries joint and in individual projects are currently planned and underway by both boards on the topic of financial instrument reporting including projects on the following topics; Financial statement presentation; Amendment of hedge accounting requirements in Statement 133; Disclosures about derivative instruments; Liabilities and equity ; and derecongnition Of these projects the most important to the goal of a single measurement approach is the financial statement presentation project. As discussed later in the paper one of the keys to the acceptance of a single measurement seems to be disaggregation of the change in fair value form one reporting period to the next. The Chartered Financial Analyst (CFA) Institute expressed this view in their comment letter in response to the ISAB Discussion Paper on Reducing Complexity in Reporting Financial Instruments. The Institute also expressed its concerns that the financial reporting topic and financial measurement and recognition topics were not being addressed with holistic approach.
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The changes apparent in guidance provided by the exposure draft of IFRS 9 are most reflective of an attempt to reduce the number of categories which financial instruments are reported under. This appears to be an attempt to bridge current standards with the long term goal of a single category.
In reviewing the accounting treatment prescribed by each board's standards many small differences are also apparent. Some of the more prominent differences describe in the following paragraphs.
Guidance relating to appropriate classification investment securities can be found for GAAP and International standards under ASC 320-10-25-1 and IAS paragraph 46 respectively. There are two apparent differences in the classification. ASC 320-10-25-1 is clear to point out that classification of financial instruments should be performed at acquisition. IAS 39 does not mention the need to classify into categories financial instruments until subsequent measurement, although this difference may or may not bear any practical difference in application. The most evident difference is the different number of categories and definition of categories provided by the two standards. The three categories required by ASC 320-10-25-1 are trading Securities, available for sale securities, and held-to-maturity-securities. IAS prescribes that for the purposes of subsequent measurement of financial assets each is classified into the following categories; financial assets at fair value through profit or loss; held-to-maturity investments; loans and receivables; and available-for-sale financial assets.
Once of the most recent efforts to form a bridge between the long-term goal of a single measure of valuation used for all instruments and the current standards of the respective boards is the release of IFRS 9 by the IASB. There has been discussion of FASB adopting.
One strong historical criticism against fair value accounting has been that the use of fair value would increase earnings volatility. As this argument points out through the use of mark-to-Market accounting earnings may reflect accounting noise rather than the true underlying change in the underlying values of investment value drivers (Banking & Capital Markets PWC). To prevent this FASB has created methods for certain securities to be revalued at fair value each year but for the changes in the valuation to be recorded directly to the balance sheet as accumulated other comprehensive income while bypassing the income statement. This "mixed attribute approach was briefly discussed earlier in this paper. After review of this approach it now appears that the solution falls into the category of being pragmatic in nature leading accounting standards which are more normative than positive in nature. This has been a criticism of GAAP since the predecessors of the FASB. The pragmatic approach has led to a myriad of accounting rules that appear to have been created haphazardly. The complicated reporting guidance provided by the FASB has contributed to the complexity of financial reporting for financial instruments. It is difficult to say if any new standards would evade the persistent amendments of prior statements which have resulted in such complexity.
A debate is underway not only to identify if the complex mean of the mixed attribute model justifies the ends of reduced reported earnings volatility but if the goal of decreased reported earnings volatility is even a desired state. The point of contention is whether these muted earning better represent the economics underlying the situation or if mark-to-market accounting does.
Much debate around this issue includes the following critical questions which. What part did fair market value accounting play in the build up to creating the conditions for the crisis? What role did mark-to-market accounting play in the spread or in the exacerbation of the crisis? An in-depth discussion of this topic can be found in the report prepared by the SEC as required by Section 133 of the Emergency Economic Stabilization Act of 2008: "Study on Mark-To-Market Accounting". The SEC staff reported their result that they did not believe that fair value accounting was a meaningful contributing factor in the banking failures during the financial crisis of 2008. They concluded that the failures were probably a result of a massing of expected credit losses. This topic is still subject to much academic research though and the conclusions
In recent years many financial and economic indicators and data have displayed information "that could not be explained existing models, mindsets, or prior experience." These "aberrations" and "Conundrums" were dismissed as being just a result of "noise". These signals were in most cases not noise but rather the beginning of the financial and credit crisis that devastated the international financial and business markets. (Mohamed A. El-Erian p19) It has to be considered if in muting the volatility of unrealized gains and losses through other comprehensive income less attention may be given to changes in fair value which may or may not be a result of a deeper systematic shift than the presentation may lead stake holders to conclude.
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Much wisdom does underlie the history of FASB to curb large year to year variations in reported earnings related to the environment outside