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11.10.2012: FASB Preps Fix for Credit Risk Reporting Glitch

As part of the ongoing debate over how best to account for financial instruments, the Financial Accounting Standards Board is preparing to retreat on an aspect of a fair value rule it adopted in 2007 that allows a company's profit to rise when the value of its debt diminishes.

FASB has reached some tentative decisions under its massive overhaul of financial instrument accounting that a company would present gains that materialize when its credit risk rises in “other comprehensive income,” a component of equity, rather than net income. An entity that accumulates gains and losses in OCI as a result would recognize those gains or losses through net income when it eventually settles the liability.

The flap over how best to account for a rise in an entity's credit risk dates back to the 2007 adoption of fair value rules that permitted some optionality about where an entity would apply greater use of fair value, says Jerry Arcy, managing director for financial advisory firm Duff & Phelps. FASB adopted the fair value option as a way to bring more fair value into accounting for financial instruments and to provide a way to simplify hedge accounting. Entities were allowed to irrevocably elect fair value to measure certain financial assets and financial liabilities, with changes in value included in net income.

That led to the head scratching over the effect of applying fair value to debt when an entity's credit worthiness is falling; when the fair value of the debt falls, that change in value ultimately flows to earnings as an apparent profit. “In the fair value world, it appears some may be misusing this,” says Arcy. “A company can be deteriorating in terms of its financial results but still be booking gains because the value of its debt is declining. So if historical debt on the balance sheet is trading down in price, it creates the illusion of a gain.”

Financial institutions in particular have hammered on the disconnect and called on FASB to address it in the context of the board's current project to rewrite the accounting rules for financial instruments, in part to make them more closely aligned with international standards. FASB agreed in June it would establish a bypass for earnings produced by an entity's declining creditworthiness, shuttling those earnings to OCI instead of net income. FASB also agreed that gains or losses that accumulate in OCI as a result of such accounting ultimately would be recognized in net income when an entity eventually settles the debt.

Those decisions aren't final until FASB publishes a new exposure draft, accepts comments, deliberates any further changes and ultimately adopts a final standard. In the meantime, it's still a topic of lively debate, says Arcy. “It's been a big struggle the last few years,” he says. As FASB considers and pursues many changes to the way financial instruments are classified, measured, and impaired, or written down in value, the effects of the changes are interrelated. “If you revisit what you do on the left side of the balance sheet, you have to revisit what you are doing on the right side of the balance sheet,” he says. “There's still a lot of discussion on this.”

 

Source: Compliance Week

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