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FROM: SEP-OCT 2009 ISSUE | BY STEPHEN SPECTOR
Earlier this year, the IASB began a project to improve the decision-usefulness of financial statements for users by simplifying the classification and measurement requirements for financial instruments. The goal of the project was to eventually replace IAS 39, Financial Instruments: Recognition and Measurement with a new standard. Another objective of the project was to reduce or possibly eliminate inconsistencies between US GAAP and IFRS in accounting for financial instruments. Doing so would enable comparisons to be made more easily between entities applying IFRS and those using US GAAP. In order to work towards convergence of their requirements, both the IASB and the US Financial Accounting Standards Board (FASB) reconsidered the classification, measurement, and impairment of financial instruments.
A key goal of the project is the elimination of “intent-based” measurement and recognition issues. Under current GAAP (Section 3855 and/or IAS 39), a financial asset can be classified three different ways – as held for trading, available for sale, or held to maturity – depending largely on management intent. The IASB proposed abolishing these classifications and replacing the measurement rules with just two alternatives: fair value or amortized cost, and there would be no reclassification between the two measurement methods after initial recognition. By having a relatively clear distinction, management intent would not be a factor.
Furthermore, the ability to use the amortized cost method would be restricted. The primary principle adopted by the IASB is that a financial instrument would be eligible for amortized cost measurement only if all its cash flows represent principal and interest. The underlying notion is that amortized cost provides useful information to users only if a financial instrument has basic loan features and it can be demonstrated that the financial instrument is managed on a contractual yield basis. For all other instruments, the IASB believes that only fair value provides useful information to users.
Another change proposed by the IASB would relate to what is currently called “tainting.” Under Section 3855 (and IAS 39), if an enterprise designates an investment as held to maturity, then it is not permitted to reclassify that investment. For example, if SRL Ltd. acquires $100,000 face value of Government of Canada bonds due July 1, 2011, and at the time of acquisition, designates the investment as held to maturity, it is assumed (and confirmed by the auditors) that SRL has both the intent and ability to hold the investment until maturity.
Now, suppose a business opportunity arises for SRL and it wishes to use $35,000 of the $100,000 it has “parked” in held to maturity investments. Current GAAP suggests that SRL may have to reclassify the remainder of the investment as available for sale. It is unlikely that the opportunity meets the criteria specified in paragraphs 3855.26 to 3855.30. Consequently, paragraph 3855.26 would preclude SRL from treating the balance of the investment as held for trading, with the concomitant outcome being the need to recognize previously unaccounted for gains or losses.
The IASB intends to change that approach. There will be no tainting requirements for financial instruments measured at amortized cost. The tranche remaining would continue to be accounted for as held to maturity. Any gains and losses on sales of instruments measured at amortized cost would be separately presented in the statement of comprehensive income. The benefit of this change is that management may be more willing to undertake opportunities that it might previously have avoided.
Other aspects of the project include:
- Retention of a fair value option at initial recognition of a financial instrument if use of the option eliminates or significantly reduces a measurement or recognition inconsistency.
- A principle to determine equity instruments whose fair value changes shall be recognized in Other Comprehensive Income (OCI). There would be no recycling or impairment for such instruments.
Finally, the IASB seems ready to propose eliminating the cost exemption in IAS 39 for unquoted equity instruments. It is doubtful such a change would make it forward – how would these instruments be valued?
The IASB’s goal is to publish for public comment an exposure draft on the classification and measurement of financial instruments such that it could issue a final standard in time for 2009 year-end financial statements. At the time this article was written, the ED had yet to be released.
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