Fergus Condon and Olivia Regan outline the key differences between US GAAP and IFRS 9, and the practical issues reporters should be aware of.
The Financial Accounting Standards Board (FASB) recently issued Accounting Standard Update 2016-01, Financial Instruments – Overall: Recognition and Measurement of Financial Assets and Financial Liabilities (the ASU). This update aims to enhance the reporting model for financial instruments in order to provide users of financial statements with more decision-useful information.
Convergence or not?
The FASB and the International Accounting Standards Board (IASB) initially embarked on a joint project to achieve convergence of their respective standards in relation to financial instruments. While convergence was achieved in some areas, the ASU has moved further away from the requirements included in the original proposed ASU from 2013. That proposal was consistent with the requirements of IFRS 9: Financial Instruments in terms of linking the measurement of an entity’s financial assets to its cash flow characteristics and taking consideration of the company’s business model. The ASU issued in January 2016 contains targeted improvement only, and retains much of the current framework for accounting for financial instruments. The areas of change introduced by the ASU can be summarised as follows:
- Equity investments to be measured at fair value with changes reflected in net income;
- Simplification of impairment assessment of equity instruments without readily-determinable fair values by requiring a qualitative assessment in the first instance. Where this qualitative assessment indicates that an impairment exists, only then must an entity measure the investment at fair value;
- No longer a requirement to disclose the fair value of financial instruments measured at amortised cost for entities that are not public business entities;
- Entities must now present separately in Other Comprehensive Income (OCI) the portion of change in the fair value of a liability that is attributable to a change in the instrument-specific credit risk where the entity has elected to measure the liability at fair value; and
- Entities must separately present financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet, or in the notes to the financial statements.
An assessment also needs to be performed in relation to the requirement for a valuation allowance on a deferred tax asset related to ‘available for sale’ securities in combination with the entity’s other deferred tax assets. This was influenced by the fact that the Prudential Regulators were concerned about banks recognising assets based on net operating losses when they were making no profits.
In our view, the changes made in respect of the elimination of the ‘available for sale’ classification allowed under ASC 320-10 for equity securities and the requirement to now carry these at fair value with changes reflected in net income will have most impact on companies as it will inevitably result in additional volatility in the income statement. The ASU makes a distinction between equity investments with and without readily-determinable fair values.
Equity investments
Equity investments (other than those accounted for using the equity method, or that result in the consolidation of the investee) with readily-determinable values are now required to be measured at fair value through earnings.
Where a company has equity investments that do not have readily-determinable fair values, it can avail of a practicability exception whereby it can make an election on a security-by-security basis to account for these investments at cost, with adjustments for impairment and observable price changes in orderly transactions for the identical or a similar investment of the same issuer reflected in earnings. Once this election is made for a security, the company must continue to account for it in this way until it no longer qualifies – for example, if the security is traded.
Companies availing of this exception should not do so without consideration of the impact to business processes. For example, the implementation guidance of the ASU refers to making a “reasonable effort” to identify price changes that are known or that can reasonably be known. While not explicitly required by the ASU, it is our view that companies should have some processes or controls in place to identify observable prices for the same or similar securities and to adopt policies for determining what types of securities would be considered similar. It would also ensure that the security in question continues to meet the qualifying criteria in order to be able to avail of this exception.
Readily-determinable fair value
An equity security has a readily- determinable fair value if it meets any of the following conditions:
- The fair value of an equity security is readily determinable if sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the U.S. Securities and Exchange Commission (SEC) or in the over-the-counter market, provided that those prices or quotations for the over-the-counter market are publicly reported by the National Association of Securities Dealers Automated Quotations systems or by Pink Sheets LLC. Restricted stock meets that definition if the restriction terminates within one year;
- The fair value of an equity security traded only in a foreign market is readily determinable if that foreign market is of a breadth and scope comparable to one of the U.S. markets referred to above; and
- The fair value of an investment in a mutual fund is readily-determinable if the fair value per share (unit) is determined and published and is the basis for current transactions.
The single step impairment model
For equity investments without a readily-determinable value, the ASU requires an entity to perform a qualitative impairment assessment at each reporting date. Only where the qualitative assessment indicates that an impairment exists will the entity need to estimate the fair value of that investment and recognise any impairment loss in current earnings.
While the ASU does provide an example of some impairment indicators, significant judgement will be required by entities in determining when an impairment indicator is significant enough to warrant a full quantitative evaluation. One example is if there is a significant deterioration in the earnings performance of the investee. There is no definitive requirement to automatically move to a qualitative assessment when there is more than a 50% probability that the deterioration in profits will lead to an impairment. It is also worth noting that if an impairment is recognised on a security for which the practicability exception is being used, it cannot be reversed unless an observable price change supports an upward adjustment to the carrying amount.
Valuation allowance for deferred tax assets
For debt securities, which can continue to be classified as available for sale with related movements in fair value being recognised in OCI, a deferred tax asset will also be recognised in OCI where there are unrealised losses on these securities.
Current US GAAP practice is to assess the need for a valuation allowance on that component of the deferred tax asset in isolation. The ASU requires the deferred tax asset of the entity to be reviewed in totality in determining a valuation allowance.
Instrument-specific credit risk
Under current US GAAP, where an entity has elected to use the fair value option for financial liabilities, changes in instrument-specific credit risk is somewhat counterintuitively reflected in current earnings. The ASU requires such changes to be reflected in OCI and only recycled to current earnings if the financial liability is settled before maturity.
This amendment reflects pressure from prudential regulators and others who argue that recognising gains when an entity’s own credit risk is being downgraded flies in the face of income statement credits being reflective of good performance.
Transition and effective date
The ASU is effective for public business entities (PBEs) for years beginning after 15 December 2017 including interim periods within those fiscal years. All other entities must apply the guidance for years beginning after 15 December 2018 and interim periods within fiscal years beginning after 15 December 2019. The impact on transition should be applied prospectively in relation to:
- The practicability exception for equity securities without readily-determinable fair values that exist as of the adoption date; and
- The requirement for PBEs to determine the fair value of financial instruments measured at amortised cost in accordance with an exit price notion under ASC 820.
Early adoption of the provision to record fair value changes for financial liabilities under the fair value option resulting from instrument-specific credit risk in OCI is available to all entities.
Fergus Condon is Partner in Financial Accounting and Advisory Services at Grant Thornton. Olivia Regan is Director in Financial Accounting and Advisory Services at Grant Thornton.