Monday, November 10, 2008

European Commission Says IASB Must Urgently Provide Guidance on Embedded Derivatives in CDOs and Reclassification Out of Fair Value

The European Commission has endorsed the IASB’s recent ameliorating changes to fair value accounting standards. The IASB standards are consistent with changes made to fair value accounting by FASB and the SEC’s Office of the Chief Accountant. At the same, the Commission said that urgent action is needed to clarify the status of embedded derivatives in collateralized debt obligations.

The European Commission has conformed its fair value standards in order to ensure that EU companies have the same flexibility as their US competitors to reclassify assets held for trading into the held-to-maturity category as permitted under IASB-clarified IAS 39.

But in a letter to the IASB, the Commission cited an urgent need to ensure that financial assets presently classified under the fair value option can be reclassified into other categories and not measured at fair value under the same conditions as the assets reclassified out of the held-for-trading categories. There is also an urgent need to clarify whether synthetic collateralized debt obligations include embedded derivatives. Finally, the Commission said that adjustments to impairment rules applicable to available for sale financial assets must be made. The Commission said that these clarifications must be done in December in order to allow preparers time to draw-up year-end financial statements.

Currently, under IAS 39, an initial decision to apply the fair value option to an instrument cannot subsequently be changed; and thus the instrument cannot be reclassified. The Commission said it is important to allow the reclassification into other categories of instruments to which fair value was initially applied.

There is currently a difference in the treatment of embedded derivatives under IFRS and US GAAP. IAS 39 has consistently been interpreted to require separation of an embedded credit derivative in a synthetic collateralized debt obligation investment. EU companies thus have to account separately for embedded derivatives and measure them at fair value. In contrast, US GAAP does not require an embedded derivative to be recognized separately. Thus, the Commission said it was urgent for the IASB to clarify whether synthetic CDOs include embedded derivatives.