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The Future of Financial Instrument Accounting

Introduction

At the joint meeting of the International Accounting Standards Board (IASB) and the USA Financial Accounting Standards Board (FASB) in October 2005, both boards acknowledged that the current accounting requirements for financial instruments under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Practice (GAAP) are too complex and require simplification. 1 To this end the two boards have agreed on four long-term objectives for accounting for financial instruments.

These long term objectives are:

1. to require that all financial instruments be measured at fair value with the realised and unrealised gains and losses being recognised in the period in which they occur;
2. to simplify or eliminate the need for special hedge accounting;
3. to develop appropriate classification criteria for liabilities and equity; and
4. to develop a new statement for derecognition of financial instruments.1

The boards have agreed that the development of the long-term objectives does not prohibit either of them from undertaking their own shorter-term projects that will support the attainment of the long-term objectives. To date, the boards have undertaken the following projects as steps to achieve the long-term objectives:

1. The fair value option of International Accounting Standards
   (IAS) 39 -- Financial Instruments: Recognition and Measurement and Financial Accounting Statement (FAS) 159: The Fair Value Option for Financial Assets and Financial Liabilities; and
2. Fair value measurements1, this project is not specific to financial instruments but will impact the measurement of financial instruments measured at fair value.

The remainder of this article provides a high level overview of the above projects and considers some of the more contentious matters arising from these projects.

The fair value option of IAS 39 and FAS 159

For periods beginning on or after 1 January 2006, IAS 39 allows for financial instruments meeting certain criteria to be designated as held at fair value with changes in fair value recorded in profit or loss. The following alternative criteria were established for the use of the fair value option:

• The use of the fair value option would eliminate an accounting mismatch.
• The financial instrument was managed on a fair value basis.
• The contract contained an embedded derivative and the entire contract was measured using the fair value option.

The FASB has subsequently issued FAS 159, which sets out the US GAAP requirements to measure financial instruments at fair value, with realised and unrealised gains and losses being included in profit or loss for the period.

Fair value measurements

FAS 157 -- Fair Value Measurements was issued by the FASB effective for periods beginning on or after 15 November 2007. The IASB then issued FAS 157 as a discussion paper for comment in November 2006.

FAS 157 describes the manner in which fair value should be determined where fair value is considered to be the appropriate measurement attribute. The statement does not prescribe when fair value is the appropriate measurement attribute.

FAS 157 defines fair value as “the price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. This is an exit value.

The statement allows for the use of observable and unobservable inputs to determine fair value.

Unobservable inputs will need to be derived from a market participant point of view. A market participant is broadly defined as a buyer or seller in the principal (or most advantageous) market that is not a related party, is knowledgeable and is able to transact for the asset or liability. The implication of this is that entity specific measurements often used currently will no longer be acceptable.2 The IASB has stated in the discussion paper that it believes that the market participants as defined in FAS 157 are comparable with the "knowledgeable, willing parties in an arms length transaction" as defined in IFRS.

The following three areas are some of the more contentious within FAS 157 (and the discussion paper) relating to financial instruments:

1) Entry Price versus Exit Price

FAS 157 makes it clear that entry and exit prices differ conceptually. The transaction price is a current entry price. The statement goes on to list a number of instances where the transaction price would differ from the exit price. These include transactions with related parties, forced transactions, transactions where the unit of account for the sale differs from the unit of account for measurement, and the use of different markets for sale and valuation.

The current version of IAS 39 is not clear on whether the measurement objective is based on current entry or exit value principles. Currently IAS 39 requires that where fair value is determined on a basis other than market observable inputs no gain or loss may be recognised on initial recognition (so-called day 1 gains and losses). Fair value on initial recognition is therefore calibrated to transaction price.

Under the exit value approach, in FAS 157 a gain or loss can be recognised on day 1 even if the valuation comprises inputs not observable in an active market.3 This is a significant departure from the current IAS 39 requirements.

2) Issues relating to the fair value measurement of liabilities

FAS 157 requires liabilities, for which fair value is considered to be the appropriate measurement attribute, to be measured at the value that they could be transferred at. The definition of fair value in IAS 39 refers to the amount at which a liability can be settled, i.e. a settlement objective. The settlement objective is subject to a demand floor minimum for financial liabilities with a demand feature. However, the statement gives preference to prices observable in an active market. Currently a liability may be valued at an amount that differs from the settlement amount where there are prices quoted in an active market.3 IAS 39 currently also requires that credit risk is included as an input to valuation techniques used to value financial liabilities not traded in an active market.

FAS 157 requires the risk of non-performance to be included in the value of liabilities measured at fair value. The risk of non-performance includes the issuer's own credit risk. Industry has raised concerns over the apparent anomaly created when the company's credit rating deteriorates. If a company measuring a liability at fair value has a credit downgrade, the liability will decrease in value, which would result in an increase in income and shareholder equity.

The Chartered Financial Analyst Institute supports the use of fair value to measure all assets and liabilities4. It believes that the increase in shareholder value resulting from a credit downgrade is "not a fluke of fair value reporting but the result of differing contractual claims of shareholders and bondholders."4 It explains that "…wealth is transferred from the existing bondholders, who have already committed to an interest rate and thus bear the risk of changes in interest rates to the shareholders. If bondholders had waited to purchase the obligations they may well have received a higher interest rate".4

The discussion paper on Preliminary views on Insurance contracts, issued by the IASB in May 2007, provides further argument for the inclusion of credit risk in the valuation of a liability. The abovementioned discussion paper states that few people would doubt that the initial measurement of debt issued for cash should reflect the credit characteristics of the debt. The paper goes on to state that a measurement model would be inconsistent if it included certain characteristics at inception but ignored subsequent changes in their effect.

3) Most advantageous/ Principal market

IAS 39 paragraph AG 71 states that the "objective of determining fair value for a financial instrument that is traded in an active market is to arrive at the price at which a transaction would occur at the balance sheet date in that instrument in the most advantageous market to which the entity has immediate access".

IAS 39 paragraph BC 98 provides the following example of the most advantageous market. A trader may originate a derivative in an active corporate retail market. The trader also has immediate access to the active dealers' wholesale market. The fair value under IAS 39 would be determined based on the price that is the more advantageous of these two markets.

In contrast to the above current practice, FAS 157 requires an entity to value the instrument based on the value in the principal market. Only in the absence of a principal market would an entity look to the most advantageous market in order to determine a value.3

Conclusion

Although the boards have made some progress towards their long-term goals of simplified accounting statements for financial instruments, these are not without their own complexities and implementation difficulties. It will take some time before a complete and simplified model for accounting for financial instruments is in place. The next step for the IASB in the fair value measurement project will be to hold round table discussions followed by the issue of an exposure draft in 2008. In respect of the financial instruments project it is expected that the IASB will issue a discussion paper in the fourth quarter of 2007.

It is important for preparers to consider each step that the boards take, and understand the impact on their financial statements.

1. IASB (International Accounting Standards Board). 2006. Project update
   18 January 2006. Available on www.iasb.org
2. PricewaterhouseCoopers. 2006. Dataline 2006-25 FASB Standard on fair value measurements – An overview of the standard's key provisions and its implications.
3. IASB (International Accounting Standards Board). 2007. Agenda paper 6 – Financial Instruments working group April 2007 Meeting. Available on www.iasb.org
4. CFA Institute, Centre for Financial Market Integrity. 2005. A Comprehensive Business Reporting Model.

Nicole Hafkamp CA(SA), MCom is an Audit Manager at PricewaterhouseCoopers in the Financial Services - Insurance and Investment management division.

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