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US GAAP vs. IFRS: the basics, March 2010 - Financial instruments - Ernst & Young - United States

US GAAP vs. IFRS: the basics, March 2010

Financial instruments

Similarities

The US GAAP guidance for financial instruments is contained in several standards, including, among others: ASC 310-10-35 Receivables — Subsequent Measurement (formerly FAS 114); ASC 320 Investments — Debt and Equity Securities (formerly FAS 115); ASC 470 Debt (formerly a variety of authoritative guidance); ASC 480 Distinguishing Liabilities from Equity (formerly FAS 150); ASC 815 Derivatives and Hedging (formerly FAS 133); ASC 820 Fair Value Measurements and Disclosures (formerly FAS 157); ASC 825-10-25 Financial Instruments — Recognition (formerly FAS 159); ASC 825-10-50 Financial Instruments — Disclosures (formerly FAS 107); ASC 860 Transfers and Servicing (formerly FAS 140); and ASC 948 Financial Services — Mortgage Banking (formerly FAS 65).

IFRS guidance for financial instruments, on the other hand, is limited to IAS 32 Financial Instruments: Presentation, IAS 39 Financial Instruments: Recognition and Measurement, IFRS 7 Financial Instruments: Disclosures and IFRS 9 Financial Instruments. IFRS 9 addresses classification and measurement of financial assets. IFRS 9, which was issued in November 2009, is not effective until annual periods beginning on or after 1 January 2013, although early application is permitted.

This publication does not address the differences between US GAAP an IFRS resulting from IFRS 9 because of the delayed effective date. Both US GAAP and IFRS require financial instruments to be classified into specific categories to determine the measurement of those instruments, clarify when financial instruments should be recognized or derecognized in financial statements, require the recognition of all derivatives on the balance sheet, and require detailed disclosures in the notes to the financial statements for the financial instruments reported in the balance sheet.

Hedge accounting and use of a fair value option is permitted under both.

Significant differences


US GAAPIFRS
Debt vs. equity
ClassificationUS GAAP specifically identifies certain instruments with characteristics of both debt and equity that must be classified as liabilities.

Certain other contracts that are indexed to, and potentially settled in, a company’s own stock may be classified as equity if they: (1) require physical settlement or net-share settlement, or (2) give the issuer a choice of net-cash settlement or settlement in its own shares.

Classification of certain instruments with characteristics of both debt and equity focuses on the contractual obligation to deliver cash, assets or an entity’s own shares. Economic compulsion does not constitute a contractual obligation.

Contracts that are indexed to, and potentially settled in, a company’s own stock are classified as equity if settled by delivering a fixed number of shares for a fixed amount of cash.

Compound (hybrid) financial instrumentsCompound (hybrid) financial instruments (for example, convertible bonds) are not split into debt and equity components unless certain specific conditions are met, but they may be bifurcated into debt and derivative components, with the derivative component subjected to fair value accounting.Compound (hybrid) financial instruments are required to be split into a debt and equity component and, if applicable, a derivative component. The derivative component may be subjected to fair value accounting.
Recognition and measurement
Impairment recognition — Available for Sale (AFS) debt instrumentsDeclines in fair value below cost may result in an impairment loss being recognized in the income statement on an AFS debt instrument due solely to a change in interest rates (risk-free or otherwise) if the entity has the intent to sell the debt instrument or it is more likely than not that it will be required to sell the debt instrument before its anticipated recovery. In this circumstance, the impairment loss is measured as the difference between the debt instrument’s amortized cost basis and its fair value. When a credit loss exists, but the entity does not intend to sell the debt instrument, nor is it more likely than not that the entity will be required to sell the debt instrument before the recovery of the remaining cost basis, the impairment is separated into (i) the amount representing the credit loss and (ii) the amount related to all other factors. The amount of the total impairment related to the credit loss is recognized in the income statement and the amount related to all other factors is recognized in other comprehensive income, net of applicable taxes.Generally, only evidence of credit default results in an impairment being recognized in the income statement for an AFS debt instrument. The impairment loss is measured as the difference between the debt instrument’s amortized cost basis and its fair value. Impairment losses for debt instruments classified as available-for-sale may be reversed through the income statement if the fair value of the instrument increases in a subsequent period and the increase can be objectively related to an event occurring after the impairment loss was recognized.
When an impairment loss (for both debt and equity instruments) is recognized in the income statement, a new cost basis in the instrument is established equal to the previous cost basis less the impairment recognized in earnings. Impairment losses recognized in the income statement cannot be reversed for any future recoveries.Impairment losses for debt instruments classified as available-for-sale may be reversed through the income statement if the fair value of the instrument increases in a subsequent period and the increase can be objectively related to an event occurring after the impairment loss was recognized.
Impairment recognition — Available for Sale (AFS)equity instrumentsFor an AFS equity instrument, an impairment is recognized in the income statement if the equity instrument’s fair value is not expected to recover sufficiently in the near-term to allow a full recovery of the entity’s cost basis. An entity must have the intent and ability to hold an impaired equity instrument until such near-term recovery; otherwise an impairment loss must be recognized in the income statement. The impairment loss is measured as the difference between the equity instrument’s cost basis and its fair value.For an AFS equity instrument, an impairment is recognized in the income statement when there is objective evidence that the AFS equity instrument is impaired and the cost of the investment in the equity instrument may not be recovered. The impairment is measured as the difference between the equity instrument’s cost basis and its fair value. A significant or prolonged decline in the fair value of an equity instrument below its cost is considered evidence of an impairment.
Impairment recognition — Held-to-Maturity (HTM) debt instrumentsThe impairment loss of an HTM instrument is measured as the difference between its fair value and amortized cost basis. Because an entity has asserted its intent and ability to hold an HTM instrument to maturity (that is, the entity does not intend to sell the debt instrument and it is not more likely than not the entity will be required to sell the debt instrument before recovery of its amortized cost basis), the amount of the total impairment related to the credit loss is recognized in the income statement and the amount related to all other factors is recognized in other comprehensive income.

The carrying amount of an HTM investment after the recognition of an impairment is the fair value of the debt instrument at the date of the impairment. The new cost basis of the debt instrument is equal to the previous cost basis less the impairment recognized in the income statement. The impairment recognized in other comprehensive income is accreted to the carrying amount of the HTM instrument through other comprehensive income over its remaining life.

The impairment loss of an HTM instrument is measured as the difference between the carrying amount of the instrument and the present value of estimated future cash flows discounted at the instrument’s original effective interest rate. The carrying amount of the instrument is reduced either directly or through use of an allowance account. The amount of impairment loss is recognized in the income statement.
Hedging
Hedge effectiveness — shortcut method for interest rate swapsPermitted.Not permitted.
Hedging a component of a risk in a financial instrumentThe risk components that may be hedged are specifically defined by the literature, with no additional flexibility.Allows entities to hedge components (portions) of risk that give rise to changes in fair value.
Hedge effectiveness — inclusion of option’s time valuePermitted.Not permitted.
Derecognition
Derecognition of financial assetsDerecognition of financial assets (sales treatment) occurs when effective control has been surrendered over the financial asset. Control has been surrendered only when:
  • The transferred financial assets are legally isolated from the transfer or
  • Each transferee (or, if the transferee is a securitization entity, each holder of its beneficial interests ), has the right to pledge or exchange the transferred financial assets or (or beneficial interests)
  • The transferor does not maintain effective control over the transferred financial assets or beneficial interests (e.g., through a call option or repurchase agreement)
The derecognition criteria may be applied to a portion of a financial asset only if it mirrors the characteristics of the original entire financial asset.		Derecognition of financial assets is based on a mixed model that considers both transfer of risks and rewards and control. Transfer of control is considered only when the transfer of risks and rewards assessment is not conclusive.

If the transferor has neither retained nor transferred substantially all of the risks and rewards, there is then an evaluation of the transfer of control. Control is considered to be surrendered if the transferee has the practical ability to unilaterally sell the transferred asset to a third party, without restrictions. There is no legal isolation test.

The derecognition provisions may be applied to a portion of financial asset if the cash flows are specifically identified or represent a pro rata share of the financial asset or specifically identified cash flows.

Loans and receivables
Measurement — effective interest methodRequires catch-up approach, retrospective method or prospective method of calculating the interest for amortized cost-based assets, depending on the type of instrument.Requires the original effective interest rate to be used throughout the life of the instrument for all financial assets and liabilities, except for certain reclassified financial assets, in which case the effect of increases in cash flows are recognized as prospective adjustments to the effective interest rate.
Measurement — loans and receivablesUnless the fair value option is elected, loans and receivables are classified as either (1) held for investment, which are measured at amortized cost, or (2) held for sale, which are measured at the lower of cost or fair value.Loans and receivables are carried at amortized cost unless classified into the “fair value through profit or loss” category or the “available for sale” category, both of which are carried at fair value on the balance sheet.
Fair value
MeasurementOne measurement model whenever fair value is used (with limited exceptions). Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Fair value is an exit price, which may differ from the transaction (entry) price.

Day one gains and lossesEntities are not precluded from recognizing day one gains and losses on financial instruments reported at fair value even when all inputs to the measurement model are not observable. For example, a day one gain or loss may occur when the transaction occurs in a market that differs from the reporting entity’s exit market.Day one gains and losses are recognized only when all inputs to the measurement model are observable.
Bid-ask spreadThe price within the bid-ask spread that is the most representative of fair value in the circumstances is used to measure fair value. However, entities are not precluded from using mid-market pricing as a practical expedient for measuring fair value.The fair value of assets held (or liabilities to be issued) is generally determined using the current bid price, while liabilities held (or assets to be acquired) are measured using the current ask price. When an entity has assets and liabilities with offsetting market risks, it may use mid-market prices to determine the fair value of the offsetting positions, and apply the bid or ask price (as appropriate) to the net open position.

Other differences include:

  1. application of fair value measurement principles, including use of prices obtained in ‘principal’ versus ‘most advantageous’ markets and estimating the fair value of certain alternative investments (e.g., investments in private equity funds) using net asset value of the investment as a practical expedient
  2. definitions of a derivative and embedded derivative
  3. cash flow hedge — basis adjustment and effectiveness testing
  4. normal purchase and sale exception (v) foreign exchange gain and/or losses on AFS investments
  5. recognition of basis adjustments when hedging future transactions
  6. macro hedging
  7. hedging net investments
  8. cash flow hedge of intercompany transactions
  9. hedging with internal derivatives
  10. impairment criteria for equity investments
  11. puttable minority interest
  12. netting and offsetting arrangements
  13. unit of account eligible for derecognition
  14. accounting for servicing assets and liabilities

Convergence

The FASB and the IASB are engaged in projects to simplify and improve the accounting for financial instruments.

Debt vs. Equity

Both Boards are working toward issuing an Exposure Draft in the first half of 2010 that will address financial instruments with characteristics of equity. The Boards continue to discuss and develop principles to classifying financial instruments as liabilities or equity.

Recognition and Measurement

The Boards currently are engaged in a joint project on recognition and measurement of financial instruments which will address classification and measurement, impairment, and hedge accounting.

In connection with this joint project, the IASB issued IFRS 9 in November 2009 representing finalized guidance on classification and measurement of financial assets, and an Exposure Draft on impairment, Financial Instruments: Amortized Cost and Impairment. The IASB expects to issue and exposure draft on hedge accounting in the first half of 2010.

The FASB expects to issue an exposure draft early in the second quarter of 2010 that will address comprehensively the recognition and measurement of financial instruments.

Although this project is considered a joint project, both Boards are separately deliberating the issues. This has resulted in different conclusions being reached on similar issues; however, the Boards continue to have a stated commitment to achieve a converged solution for financial instruments that will provide comparability and transparency as well as reduced complexity of financial instruments accounting.

Derecognition

In June 2009, the FASB issued FAS 166, Accounting for Transfers of Financial Assets — an Amendment to FASB Statement No. 140. FAS 166, which was codified in ASC 860 and is effective for annual periods that begin after 15 November 2009. This revised guidance improves convergence by eliminating the concept of a qualifying special-purpose entity.

In March 2009, the IASB issued an exposure draft that proposed a derecognition model based on control. The proposal was not well received, although there was qualified support for an alternative model the IASB also included in the Exposure Draft.

The IASB plans to continue developing derecognition requirements based on that model. The Boards have agreed to assess in the first half of 2010 the differences between IFRS and US GAAP and will then consider together the model that the IASB has been developing.

Fair Value

In the US, the guidance in ASC 820 established a common framework for measuring fair value for all financial instruments, though it did not address the circumstances in which fair value accounting should be used.

In May 2009 the IASB published an Exposure Draft with proposed guidance regarding how fair value would be measured when it is already required by existing standards. It does not extend the use of fair value, but rather, like ASC 820, would establish a single source of guidance for all fair value measurements under existing IFRS.

The proposed guidance in the Exposure Draft is largely consistent with the principles in ASC 820 and would eliminate most of the differences between US GAAP and IFRS in this area.

However, certain proposals in the Exposure Draft differ from US GAAP as the IASB believes changes to ASC 820 are warranted to improve the guidance in some areas. In order to address these differences, the Boards are committed to work on a joint project focused on eliminating all substantive differences between the guidance in the IASB Exposure Draft and ASC 820.

The Boards are currently in the process of jointly deliberating certain aspects of their respective fair value measurement guidance and expect to complete this project and issue new guidance in the second half of 2010.

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