Hi Bob,

Here is my article.

Paul

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In June, the international Accounting Standards Committee published for comment Exposure Draft E62, Financial Instruments: Recognition and Measurement. It is an important project for IASC because it’s the final component of the "core standards" that the world’s securities regulators will be considering for endorsement next year. You can download a copy of E62 from IASC’s web site (http://www.iasc.org.uk).

IASC has been working on financial instruments since 1989. In 1995, the Board approved IAS 32, which deals with presentation and disclosure of financial instruments. E62 addresses the accounting – when to recognise and how to measure financial assets and financial liabilities.

In a nutshell, E62 would:

Put all financial assets and liabilities on the balance sheet, including derivatives.

Require that all financial assets be remeasured to fair value except those that are held to maturity and those whose fair value cannot be reliably measured.

Require that all financial liabilities be carried at amortised original amount, except for fair valuation of derivatives and liabilities held for trading.

Require that fair value adjustments for all financial assets and liabilities held for trading and all derivatives be recognised immediately in net profit or loss.

For fair value adjustments of financial assets not held for trading, allow a one-time enterprise-wide election either to recognise the adjustment in income immediately or to recognise it in equity until the asset is sold or otherwise disposed of, at which time the adjustment affects net profit or loss.

Impose an impairment test on all financial assets.

Require derecognition only when control has passed.

In certain circumstances, permit hedge accounting for designated hedges of recognised assets and liabilities and of commitments and forecasted future transactions.

The U.S. Financial Accounting Standards Board has been working on financial instruments even longer than IASC and has a number of important final standards in place. Most notable among them are FAS 114 on loan impairment, FAS 115 on investments in debt and equity securities, FAS 125 on derecognition of financial instruments, and the new FAS 133 on derivatives and hedging.

In a recent public speech that was reported in the U.S. press, an FASB board member said that FASB has identified "38 substantive differences" between E62 and US standards of accounting for financial instruments. Since I am IASC’s project manager for E62, I thought it would be useful to present my perspective on the "notorious 38":

3 are included twice on FASB’s list, leaving 35.

16 are minor omissions in E62, not differences. I feel our Board can easily clarify these in finalising our recognition and measurement standard, leaving 19.

4 are minor differences, but I am convinced that IASC has the preferred answer, though without question our Board will take another look at these issues, leaving 15.

7 are not really differences but rather minor issues addressed in more detail in the FASB standards than in E62. IASC will consider whether to add the detail, leaving 8.

2 seem to be differences more in form than in substance, leaving 6.

6 are rightly called key differences.

1. Scope. E62 applies to public companies only. The FASB standards apply to all companies. IASC limited E62 for cost-benefit reasons coupled with the knowledge that nonpublic companies will still have to provide the IAS 32 disclosures.

A few existing IASC disclosure standards apply only to public companies, notably segment reporting and earnings per share. But E62 marks the first time that asset and liability recognition and income measurement might be different for nonpublic companies. Question number one at the front of E62 is whether this distinction is wise. A possible compromise might be applicability to all enterprises but a delayed effective date for nonpublic ones.

2. Transaction costs. E62 addresses the accounting. FASB GAAP is silent. Under E62, transaction costs are included in the initial measurement of held-to-maturity investments, which will be carried at amortised cost after acquisition, but are neither included in the initial measurement of financial instruments that are remeasured to fair value after acquisition nor deducted in making the fair value remeasurements. The IASC Board felt that this is a matter that a financial instruments standard should cover.

3. Unrealised fair value changes on non-trading financial assets. E62 allows companies to make a one-time, enterprise-wide election to report a gain or loss resulting from an adjustment to fair value of a non-trading financial asset either (a) in net profit or loss for the period in which it arises or (b) directly in equity until the financial asset is sold, collected, or otherwise disposed of, at which time the gain or loss "recycles" into. US GAAP allows only option (b).

The IASC Board believes that the approach proposed in E62 accomplishes several important objectives. One is fair valuation of financial assets on the balance sheet. Another is to provide sufficient information to let users of financial statements take the value change into account in assessing performance, if they wish. And a third objective is to acknowledge that changes in fair values are part of assessing the performance of a business.

4. Test for classification as held to maturity by category. Under both E62 and US GAAP, the actual sale of more than an insignificant amount of a held-to-maturity investment calls into question a company’s intent to hold other investments to maturity. E62 permits that test to be applied separately to each major category of investment. It cites a bank’s portfolios of mortgage loans, commercial loans, and debt securities held for investment purposes as an example of categories. Under US GAAP, however, a single sale of any held-to-maturity investment taints the company’s intent to hold any investment in its entire portfolio to maturity, without regard to category.

5. Reversal of impairment write-down. E62 provides that if the amount of a previously recognised impairment of a financial asset subsequently diminishes, the recovery is reported in net profit or loss for the period. This is consistent with how IASC has answered similar questions in previous standards, for example, impairment of plant and equipment and intangibles in IAS 16 and IAS 36 and write-downs of inventories in IAS 2.

6. Nonderivatives as hedging instruments. E62 would allow non-derivatives to be designated as hedging instruments if the criteria for hedge accounting otherwise are met. While derivatives generally are acquired for hedging purposes, the link between a non-derivative and a hedged item is often harder to demonstrate or disprove. That led FASB to conclude, in FAS 133, that nonderivatives should be allowed as hedging instruments only for hedges of foreign operations and foreign currency firm commitments.

Liability with variable principal. E62 requires that the increase or decrease in principal be recognised immediately in net profit or loss. US GAAP is silent.

Fair value—adjust for sizeable block. E62 acknowledges that the fair value of a debt or equity securities may be different from the quoted market price if the position held is so large that the market price obtainable would be materially different from the published price. US GAAP says to use the quoted market price unadjusted.

Transfer into/out of trading category. To prevent "cherry picking" (creating or eliminating income or loss simply by a change of management intent), E62 says that a financial asset should be classified as held for trading at acquisition date based on the objective for initially acquiring the asset. US GAAP permits reclassification while the asset is held based on a stated change of intent.

Impairment. Under E62, an impairment loss must be recognised if the recoverable amount of a held-to-maturity investment on a discounted present value basis is below its carrying amount. IASC considered but rejected as subjective the US GAAP requirement that the loss be deemed "non-temporary."

Impairment. E62 provides that impairment be assessed either for individual assets or on a portfolio basis (such as loan loss and bad debt provisions). FAS 114 and 115 require that impairment be assessed for financial assets individually, although FAS 5 on contingencies provides an example of bad debt accruals on a portfolio basis.

Objective evidence of impairment. E62 contains a list of indicators of impairment, such as financial difficulty, payment delinquency, a high probability of bankruptcy or other financial reorganisation of the issuer, or the disappearance of an active market for the financial asset due to financial difficulties. US GAAP contains no such list.

Derecognition: legally isolate asset? US GAAP requires that a transferred asset be legally beyond the reach of the transferor’s creditors even if the transferor should become bankrupt. E62 does not have an explicit "legal isolation in bankruptcy" requirement.

Derecognition: call option on asset. E62 generally prohibits sale accounting if the transferor retains an option to buy back the assets. US GAAP allows sale accounting if the transferor could readily purchase similar assets in an open market.

Definition of held-to-maturity securities. E62 includes securities, receivables, and loans. FAS 115 includes securities only. However, in effect, FAS 5 treats receivables and loans as held to maturity in the sense of continuing to carry them at amortised cost subject to a bad debt or loan loss provision.

When a forecasted asset or liability acquisition is hedged, the gain or loss on the hedging instrument is initially reported directly in equity under E62 and FAS 133. E62 invites comment on what to do with that amount when the asset or liability acquisition actually occurs. Two options are

Remove the amount from equity and include it as part of the initial acquisition cost or other carrying amount of the asset or liability (so-called "basis adjustment").

Keep the amount in equity.

Either way, the gain or loss on the hedge affects net profit or loss when the acquired asset or liability is depreciated or amortised. The only difference is balance sheet presentation. E62 takes no position on the alternatives but invites comment. In the US, basis adjustment has been a requirement since 1984 (FAS 80) but will soon be outlawed (FAS 133).

I would add one additional difference to FASB’s list – the degree of detail in IASC’s standard compared to FASB’s. The preface to the bound volume of IASC Standards expressly states that in formulating International Accounting Standards, "IASC concentrates on essentials. It therefore endeavours not to make the International Accounting Standards so complex that they cannot be applied effectively on a worldwide basis."

FASB’s new standard on derivatives and hedging alone is 535 paragraphs and 245 pages in length. They even decided to print it on thinner paper than other final standards, to reduce its heft. FAS 125 is another 242 paragraphs and 94 pages. In contrast, E62, which covers far more than just these two FASB pronouncements, weighs in at 104 paragraphs and 64 pages.

To illustrate the differences, FAS 133 has 72 paragraphs of examples of hedge effectiveness and 25 paragraphs of examples of embedded derivatives. E62 defines hedge effectiveness and discusses it in two paragraphs. E62 discusses embedded derivatives in three paragraphs with seven brief examples.