The Current State of Financial Instrument Accounting and Reporting: Why Should Investors Care?

On 20 September, CFA Institute conducted a webcast on “The Current State of Accounting and Reporting for Financial Instruments.” Aimed at providing an investor-focused overview of FASB and IASB projects on financial instrument accounting, the discussion comes at a time when the European sovereign debt crisis and concerns regarding the solvency of some U.S. financial institutions have reignited the debate over the most relevant measure for financial instruments.

The webcast provided an overview and broader context regarding the need for investors to understand key developments in financial instrument accounting, and to evaluate whether the IASB and FASB-proposed accounting standard updates represent the economic reality of reporting entities and reduce the complexity of accounting standards. 

EU Debt Crisis
A number of issues were highlighted, including the backdrop of the significant peripheral Euro-zone sovereign exposures faced by European banks and the concomitant losses that these banks have incurred as a result of these exposures. In parallel, there have been a number of notable cases reported in the media, in which some banks appear to be at liberty to apply the full arsenal of accounting rules in order to influence loss recognition. These include reclassification from fair value to amortised cost measurement categories and application of fair value guidance in a manner that ignores market-based evidence. These developments call for a moment for pause and reflection by investors on how effective the various accounting standard updates really have been in improving transparency for securities analysis. It also is noteworthy that, unlike the 2007-2009 market crisis, there has been a shift away from blaming fair value for this particular crisis. CFA Institute has been unwavering in its support for fair value as the measurement basis for financial instruments.

IFRS Convergence
Another reason financial instrument accounting is important is that it is a key indicator of progress on convergence of IFRS and U.S. GAAP. The status of joint financial instrument accounting projects could be an evaluation factor for the U.S. SEC, as it considers whether to allow the adoption of IFRS in the U.S. You can read the CFA Institute comment letter to the SEC on this issue here.

Classification and Measurement
The webcast highlighted the classification and measurement requirements that address when to apply fair value measurement for different financial instruments. This entailed a review of the differences between the existing guidance and proposed models under both IASB and FASB approaches and the two newly proposed models of the IASB and FASB.

Our aim during the webcast was to give investors a sense of whether the work undertaken by the Boards has resulted in an improvement in the classification and measurement of financial instruments; whether the new models have reduced complexity — the original purpose of the joint project; whether these models have resolved the issues that precipitated the need for change; and whether global comparability has been increased. CFA Institute believes that these are important questions that investors need to ask themselves when evaluating these proposals and assessing whether they would provide decision-useful information to the global investment community.

Financial Assets Impairment
The webcast also highlighted the evolution of the impairment models from the IASB and FASB in response to the problem of “too little, too late” recognition of losses, as witnessed during the last financial crisis. The problem of “too little, too late” is one of delayed timing and understated amounts when recognising credit losses, and it is a feature of the incurred loss impairment model where impairments require a trigger event before loss recognition. The Boards started off with distinctive approaches during their exposure drafts, with the FASB proposing a forward-looking incurred loss model versus the expected loss model of the IASB. Thereafter, there have been two major key iterations of the impairment model with the development of the: a) “good book” and “bad book” distinction and b) three bucket approach. In the development of these latter models, the Boards have worked closely together in pursuit of a converged approach. However, when considering the number of difficult-to-resolve issues around the building blocks of the proposed impairment models, it seems evident that a very circular process has been undertaken by the standard setters in their goal of developing a suitable impairment model. At the same time, the problems of significant complexity and less relevant information remain unresolved. This also begs the question of whether the proposed approaches are any better than a fair-value-based impairment approach. Though most relevant, fair- value-based approaches have been characterised by some as being too complex, yet complexity is still a feature of these relatively less decision-useful approaches.

Hedge Accounting
The concluding section on hedge accounting highlighted the significant differences in the approaches by the two Boards in addressing hedge accounting, with the IASB proposing a significant expansion in hedge accounting in contrast to FASB, which favors a more limited scope expansion. Issues of concern for CFA Institute include the focus on risk management as the hedge accounting objective despite the lack of a solid conceptual definition of risk management; the failure to consider the interdependent nature of hedge accounting and classification and measurement requirements; and the loosely defined principles-based qualitative criteria of effectiveness. The overarching message was that there are limited benefits for expanded hedge accounting; there is need for stronger conceptual foundations, including defining risk management and strengthening the criteria for assessing effectiveness; and that the proposed disclosures need significant improvement.

Related Posts:
CFA Institute Weighs in: Premature to Choose Method of Incorporating IFRS into U.S. Financial Reporting System

EU Debt Crisis Highlights Shortcomings of Financial Instrument Accounting