IASB Proposes New Fair Value Standard, While FCAG Says Fair Value Not Pro-Cyclical

The IASB has proposed significant changes to its fair value accounting standard that would essentially require all financial instruments that do not have basic loan features to be measured at fair value. The proposal would also eliminate the requirement to identify and account for embedded derivatives separately. The IASB’s proposed approach would reduce the complexity that results from the many categories and related impairment methods in current standard IAS 39.

The draft proposes two primary measurement categories for financial instruments: amortized cost and fair value. A financial asset or financial liability would be measured at amortized cost if the instrument has loan features and is managed on a contractual yield basis. All other financial assets or financial liabilities would be measured at fair value. Therefore, the draft proposes that all investments in equity instruments, as well as derivatives on those equity instruments, should be measured at fair value.

Many commenters consider the accounting requirements in IAS 39 for embedded derivatives complex and rule-based. The draft would simplify those accounting requirements by proposing a single classification approach for all financial instruments including hybrid contracts with financial hosts.

The draft defines an embedded derivative as a component of a hybrid contract that also includes a non-derivative host, with the effect that some of the cash flows of the combined instrument vary in a way similar to the cash flows of a stand-alone derivative. If a derivative is attached to a financial instrument, but is contractually transferable independently of that instrument, or has a different counterparty from that instrument, that derivative is not an embedded derivative, but a separate financial instrument.

The exposure draft also addresses investments in contractually subordinated interests, such as tranches. The draft proposes to apply the classification criteria to such investments by requiring that any tranche that provides credit protection to other tranches on the basis of any possible outcome, rather than a probability-weighted outcome, must be measured at fair value because provision of such credit protection is a form of leverage and not a basic loan feature.

At the same time, a high level advisory group jointly formed by FASB and the IASB reported that fair value accounting was not a pro-cyclical cause of the financial crisis. The Financial Crisis Advisory Group, co-chaired by former SEC Commissioner Harvey Goldschmid, said that accounting standards actually led to an understatement of the value of financial assets.

While the crisis may have led to some understatement of the value of mark-to-market assets, noted FCAG, it must be recognized that in most countries a majority of financial institutions’ assets are still valued at historic cost using the amortized cost basis. Those assets are not marked to market and are not adjusted for market liquidity. The overall value of these assets was overstated. Further, the incurred loss model for loan loss provisioning and difficulties in applying the model, delayed the recognition of losses on loan portfolios. The group noted that the results of the US stress tests seem to bear this out. Moreover, the off-balance sheet standards, and the way they were applied, may have obscured losses associated with securitizations of complex structured products.

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