17 May 2013

Deloitte (US) commented on classification and measurement of financial instruments

Deloitte & Touche LLP commented on the FASB's proposed ASU, 'Recognition and Measurement of Financial Assets and Financial Liabilities', issued in February 2013. The comment letter compares the proposed ASU with the IASB's ED on proposed limited changes to IFRS 9 (2010), published in November 2012.

Deloitte & Touche LLP supports the Board’s objectives of (1) converging the guidance on classification and measurement of financial instruments under US GAAP with that under IFRSs, (2) reducing unnecessary complexity in the accounting for financial instruments, and (3) requiring entities to provide more decision-useful information about their involvement with those instruments.

Convergence

Deloitte & Touche LLP continues to encourage the FASB and IASB to work together to eliminate remaining areas of divergence between (1) the FASB’s proposed ASU and (2) IFRS 9 (2010)1 as it would be amended by ED/2012/42 (“IFRS 9”). To support well-functioning global capital markets, a single converged financial reporting model for financial instruments should be a top priority. Deloitte & Touche LLP is concerned that presenting both proposed models to the public as substantially converged may mislead investors and other financial statement users and dissuade them from performing appropriate comparative analysis when differences exist.

While certain principles in the proposed ASU and IFRS 9 may appear to be converged, some of the detailed application guidance differs in important respects. Such differences could sometimes result in very different accounting outcomes. For example, the FASB’s guidance on sales from the amortised cost category differs from the IASB’s. Regarding the assessment of whether sales activities from an amortised cost portfolio would be consistent with the “hold-to-collect” business model objective, the FASB provides a list of “permissible sales” while the IASB requires entities to evaluate the frequency and volume of sales. Deloitte & Touche LLP supports the FASB’s proposal to provide a list of “permissible sales” in addition to indicating that other sales should be very infrequent.

In addition, Deloitte & Touche LLP recommends that the FASB and IASB jointly redeliberate the remaining areas of divergence to eliminate significant differences, including those related to initial measurement of financial assets, initial and subsequent measurement of equity investments, and others.

Complexity

Deloitte & Touche LLP recommends that certain elements of the proposed ASU be improved to reduce unnecessary complexity and to clarify for preparers and users how to apply the proposed guidance and interpret the results.

Deloitte & Touche LLP generally supports the FASB’s proposal to simplify current US GAAP by replacing the existing embedded derivative requirements for hybrid financial assets. However, Deloitte & Touche LLP is concerned that the requirement to use a narrowly defined contractual class flow characteristics assessment to classify and measure hybrid financial assets in their entirety could force hybrid financial assets into being classified as fair value through net income (FV-NI) even if the effect that an embedded derivative has on contractual cash flows is insignificant or the likelihood of a change in cash flows is remote. Further, Deloitte & Touche LLP is concerned that the detailed application guidance on the proposed cash flow characteristics criterion is internally inconsistent and excessively complex. For example, depending on the type of feature, entities would use different types of assessments, such as the following, to determine whether an instrument meets the contractual cash flow characteristics criterion:

• A rules-based approach for assessing prepayment or extension options (paragraphs 825-10-55-21 and 55-22).
• A significance test for leverage features (paragraph 825-10-55-17).
• A benchmark instrument comparison approach for interest mismatch features under which an entity would ignore scenarios that are not reasonably possible (paragraphs 825-10-55-19 and 55-20).
• An evaluation that disregards non-genuine features (i.e. contingent terms that would affect the cash flows only upon the occurrence of an event that is extremely rare, highly abnormal, and very unlikely to occur) but otherwise would not take into account the probability of occurrence related to the assessment of other contingent features that may change the timing or amount of contractual cash flows (paragraphs 825-10-55-23 through 55-25).

Conceptually, it is unclear why different application guidance should apply to different types of features rather than a consistent set of principles. Deloitte & Touche LLP recommends that the boards develop convergent, coherent, and consistent guidance that embodies similar criteria for evaluating different types of features. More specifically, Deloitte & Touche LLP recommends that the boards provide guidance that:

• Clarifies that any non-genuine feature affecting an instrument’s contractual cash flows only on the occurrence of an event that is highly unlikely to occur should be disregarded in the assessment of an instrument’s contractual cash flows, irrespective of the type of feature that is being evaluated.
• Eliminates the differences in proposed guidance that (a) requires entities to only consider reasonably possible scenarios when evaluating modifying terms, (b) requires entities to evaluate significance in assessing leverage features, (c) in the case of contingent features, prohibits entities from considering the probability of a contingent event occurring if such an event would result in cash flows that are not solely payments of principal and interest yet requires entities to disregard non-genuine features, and (d) permits prepayment or extension options that are contingent upon the occurrence of some event if such contingency provides the holder or issuer with certain protections from unfavourable changes in cash flows.
• Requires entities to “look through” to the underlying assets both for beneficial interests in securitised assets and other non-recourse assets contractually linked to the performance of related assets.
• Requires entities to disregard terms that permit, but do not require, an investor to settle in a manner that would cause it not to receive all unpaid amounts of principal and interest (i.e. the investor could not be forced to accept such a settlement outcome).
• Requires entities to disregard terms that permit the issuer or borrower to settle in a manner that would cause the investor to receive an amount in excess of an unpaid amount of principal and interest.
• Clearly links the assessment of different types of features to the “payments of principal and interest” principle.

Further, the boards should provide guidance that clearly defines and addresses both non-recourse debt and debt that is indexed or otherwise contractually linked to the performance of underlying assets. Deloitte & Touche LLP believes the guidance should be the same or similar in the evaluation of economically similar instruments. In the case of non-recourse debt, the guidance should also clarify when asset specific risk becomes so significant that the originating entity does not provide lending but is de facto purchasing the risk or rewards inherent in an asset.

Another source of complexity in the proposed ASU is the allocation of debt instruments. Under the proposed ASU, an entity that acquires or originates a pool of instruments anticipating that a portion of the pool will be held to collect contractual cash flows and another portion sold, but has not identified which instruments will be held and which will be sold, must allocate a percentage of the instruments to appropriate classification categories. However, this guidance appears to be inconsistent with the proposed ASU’s fair value through other comprehensive income (FV-OCI) business model objective, which states, in part, that if an “entity has not yet determined whether it will hold the individual asset to collect contractual cash flows or sell the asset,” the entity’s business model is consistent with the FV-OCI category. In addition, if the Board proceeds with the guidance on pools of similar financial instruments, Deloitte & Touche LLP requests that it clarify:

• Whether an entity would allocate a percentage of the pool with the resultant portion composed of whole loans or percentages of individual loans.
• How impairment, reclassifications, write-downs, or subsequent sales should be assessed for the portions allocated to different categories and how the resultant adjustments or allowances should be allocated.
• Whether hedge accounting would be allowed and, if so, how it would be applied to individual assets (or portions of assets) within the pool. For example, if an asset in the pool is ultimately sold, how the entity would know whether the asset sold was a hedged item in whole or in part.

Decision-Useful Information

Deloitte & Touche LLP encourages the Board to conduct appropriate outreach to financial statement users to assess whether the expected results of applying the proposed ASU will provide those users with more relevant, decision-useful information. Deloitte & Touche LLP observes that the additional disclosures proposed may represent an incremental burden for preparers to gather and disclose the information that would be required but may not provide users with decision-useful information.

Press release

Full comment letter

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