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Standard Setters on Record-Setting Pace For Issuance of Fair Value Accounting Guidance
As part of an organized global effort to reduce the inconsistent measurement of fair value and the application of impairment guidance for financial assets, FASB has taken swift action with rapid expansion of fair value accounting guidance intended to provide relevant and transparent information to users of financial statements. Similarly, IASB has developed a timeframe for increasing guidance pertaining to recognition and measurement of financial instruments. FASB and IASB collaboration on these projects is paramount due to the impending convergence towards a common, international standard of financial reporting.
While the markets decline appear to have leveled off through the first half of 2009, establishing fair value for certain investments and assessing asset impairment will continue to be challenging aspects of the 2009 financial statement reporting process due to new and developing pronouncements from domestic and international standard setting organizations.
The Evolution of Investment Accounting for Insurance Enterprises
In 1982, FASB issued SFAS 60, Accounting for Insurance Enterprises, which established accounting guidance specific in nature to insurance companies. SFAS 60 required that insurance companies carry fixed maturity securities at amortized cost and equity securities at fair value. Fluctuations in fair value were reflected as unrealized gains and losses within the equity component of the balance sheet, and gains and losses realized upon disposal were recognized within earnings.SFAS 60 introduced the concept of other than temporary decline in fair value, but merely mandated that such declines be recognized as if a sale had occurred.
More than a decade later in 1993, SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, superseded the investment accounting guidance offered by SFAS 60 and established a new, categorical method for investment accounting with the introduction of the categories trading securities, available-for-sale securities and held-to-maturity securities.A major development surfaced by SFAS 115 was the need to recognize market value fluctuations as a component of earnings for securities classified in the trading category.SFAS 115 retained the other than temporary decline concept introduced in SFAS 60, and brought greater prominence to the concept of intent to hold as a means of justifying the classification of fixed maturity securities in the held-to-maturity category.
There were several shortcomings of SFAS 60 and SFAS 115 that were not fully exposed until the bull market, which began in the 90’s, was abruptly shifted into reverse during 2008. Specifically, the need for meticulous impairment analysis and the consideration of valuation when confronted with inactive markets were not exceedingly germane. The generally long-running bull market created an environment in which the concepts of other than temporary and intent ability to hold did not require extensive analysis; bright line tests such as the 20% / 6-months approach successfully weeded out the truly poor performing assets. Further, functional markets with high volumes of activity and pervasive asset inflation did not leave many people questioning the significance of a fair value methodology.
While the economic crisis of 2008 lead to the recent barrage of accounting guidance, there existed a severe, but relatively short-lived market slide subsequent to the dot-com bust and 9/11 that sparked dialogue regarding the matters raised in the preceding paragraph. In 2005, FASB issued a Staff Position (FSP), FSP 115-1, which established a framework to evaluate impairment on a security-by-security basis, the severity of the impairment, and the likelihood of recovery prior to an anticipated disposal. Unfortunately, the guidance offered in FSP 115-1 was subjective and created significant inconsistency in evaluating other than temporary impairment (OTTI), which surfaced in the insurance industry during the 2008 financial statement reporting process, when comparing the aggressiveness (or lack thereof) of impairment charges taken by one carrier to the next. While it isn’t extraordinary for two companies to reach different conclusions regarding OTTI for a particular security, due to differing conclusions about intent & ability to hold and assumptions about recoverability of the security valuation, the difficulty that exists for users of financial statements when attempting to compare one company’s performance to another is great.
With regard to the matter of valuation, in 2006, FASB issued SFAS 157, Fair Value Measurements, which offered a methodology for the determination of fair value and expanded fair value disclosure requirements.SFAS 157 did not change the recognition requirements of SFAS 115; rather SFAS 157 provided a common definition of fair value, information regarding the markets that companies should look to when measuring fair value, discussed various measurement techniques for assessing fair value, and introduced a hierarchical approach, based on inputs used to determine fair value, to enhance disclosures regarding the fair value measurement process. Unfortunately, SFAS 157 was not as clear as the standard setters had envisioned; since its original release, several FSPs and other guidance have been issued to offer clarity on the application of SFAS 157.
A Cry for Help- Recent Accounting Guidance in Response to the Economic Crisis
While one could write for weeks about what has stemmed from the recent economic crisis, the most relevant to this piece would be the SEC’s study on mark-to-market accounting, and the flow of new accounting pronouncements that has ensued subsequent to the study. In the past nine months, there have been three significant new pronouncements, each of which attempts to address issues that have arisen as a result of the economic crisis, and in response to the recommendations set forth by the SEC and reinforced by Congress:
- FSP 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active
- FSP 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly
- FSP 115-2, Recognition and Presentation of Other-Than-Temporary Impairments
FSP 157-3 was released in late 2008 at a time when markets for many types of investments became dysfunctional, leaving financial statement preparers in a precarious position when assessing fair value. FAS 157-3 retained the notion that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions.The predominant interpretation of SFAS 157 was that the maximized use of observable inputs required companies to utilize recent, unadjusted transaction prices for identical or similar assets in active or inactive markets (observable inputs). FSP 157-3 acknowledged that in some circumstances, observable inputs might require significant adjustment based on unobservable data, such as management’s internally generated assumptions and analyses.
FSP 157-4 took a step back from FSP 157-3 to pose the question, How would one know when a market is considered to be inactive, and also attempts to address the determination of a disorderly transaction. This FSP provided some common indicators of an inactive market (e.g. few recent transactions, wide bid-ask spread, etc.), and indicated that if an investment is determined to have significantly decreased volume and level of activity, reporting entities should determine if observable transactions were conducted in an orderly fashion.Indicators of a disorderly transaction include, among others, inadequate exposure to the market, the seller is in or near bankruptcy or receivership, or the seller was required to sell to meet regulatory or legal requirements.If the reporting entity determines observable prices obtained do not stem from an orderly transaction, other valuation techniques should be utilized.FSP 157-4 does not specify valuation techniques to determine the fair value of an investment (i.e. discounted cash flow models or intrinsic value methodologies); however FSP 157-4 requires footnote disclosure of the valuation techniques utilized in determination of fair value of investments.
FSP 157-3 and 157-4 effectively offered greater flexibility to move to a level three methodology, thus placing lesser reliance on market transactions that many perceived to be anything but accurate representations of fair value.FASP 157-4 also introduced the notion of using multiple valuation techniques, thereby creating a range from which a best estimate of fair value might be determined.
In April 2009, FASB issued FSP 115-2, which addresses suggestions presented in the SEC study and provides additional guidance for identifying conditions for impairing debt securities.Prior OTTI guidance focused on the intent and ability to hold a security,as the impetus for impairment recognition, while FSP 115-2 focuses on whether the entity (a) has the intent to sell the debt security, (b) more likely than not will be required to sell the debt security before its anticipated recovery, or (c) does not expect to recover the entire amortized cost basis of the security.
In the event a reporting entity does not meet the criteria of (a) and (b) above, but does meet criteria (c), the impairment guidance presented in FSP 115-2 expand reporting requirements by bifurcating (a word that should ignite fear in the world of accounting!) declines in the fair value of debt securities between declines derived from credit related factors and those derived from all other factors. If the report entity determines that either (a) or (b) are met, all losses will be recognized in a charge to earnings. Under the FSP 115-2 bifurcation guidance, credit related losses result in a charge to earnings (similar to prior OTTI guidance), while non-credit related impairment will be recognized as a component of other comprehensive income (similar to prior treatment of unrealized losses).As demonstrated by the example below, the bifurcation guidance of FSP 115-2 has no net impact to an insurance company’s GAAP equity; however, the bifurcation process will present different earnings figures than would have been presented following previous OTTI guidance, and will require more extensive record keeping on a security-by-security basis.
A Glimpse to the Future
We are currently three years into a joint commitment by FASB and IASB to improve and converge financial reporting standards, with specific, long-term objectives related to financial instruments including developing a new standard for the derecognition of financial instruments; requiring fair value measurement for all financial instruments with timely recognition of gains and losses; and simplification and/or elimination of special hedge accounting requirements. IASB elected to follow a three-phase timeline, focused first on classification and measurement, next on impairment of financial instruments and finally to address hedge reporting requirements. FASB, on the other hand, indicated a desire to address recognition, measurement and impairment simultaneously, with a subsequent focus on hedge accounting. While the two groups are progressing down slightly different paths and timelines, great consistency can be expected in the final products released by both FASB and IASB, to promote the convergence of reporting standards. Both groups are committed to final standards for the 2011 or 2012 reporting period(s).
IASB First to Strike
In July 2009, IASB issued Exposure Draft (ED) ED/2009/7, Financial Instruments: Classification and Measurement, containing proposals on the first phase of IASB’s project. This ED is open for public comment until September 14, 2009 and can be found on IASB’s website (www.IASB.org). The primary focus of this ED is to reduce complexity associated with financial instrument classification and measurement, and to remove inconsistencies between IFRS and U.S. GAAP.
Currently, international standards provide for many categories of financial instruments with varying impairment methodologies this ED seeks to consolidate the classification requirement into two categories: amortized cost and fair value.Essentially, a financial instrument that has basic loan features and is managed on a contractual yield basis would qualify for measurement at amortized cost, unless management makes an irrevocable election to measure the instrument at fair value through profit or loss. Any financial instruments not meeting the amortized cost criteria, including all equity instruments, would require fair value measurement. Examples of financial instruments meeting the amortized cost criteria include many debt securities, typical loans and trade accounts receivable, so long as they’re not held for trading purposes or acquired at discounts that reflect incurred credit losses. A significant change tabled in this ED is the recognition of unrealized gains and losses (for fair value instruments) through profit and loss, unless management irrevocably opts for recognition of unrealized gains and losses on equity securities through comprehensive income for instruments not held for trading purposes. If such an election is made, all gains and losses (including dividends) on the equity security would be recognized in comprehensive income with no recycling of gains and losses to earnings; thus, impairment analysis would be unnecessary for these instruments. Ultimately, the proposals in this ED would eliminate the need for impairment evaluation for all but those securities measured at amortized cost.
IASB expects to release another ED in October 2009 containing proposals on an impairment methodology for instruments measured at amortized cost, with a third ED in December 2009 addressing the simplification of hedge accounting.
FASB met on July 15, 2009 to deliberate categorization and measurement and recognition methods for financial statements; minutes for the meeting are not yet available, however FASB expects to release an ED during the fourth quarter of 2009 with proposals on these topics.FASB did reach several decisions at the meeting including the measurement of all financial instruments (with limited exceptions) at fair value, with unrealized gains and losses recognized in net income or comprehensive income. Presentation of fair value changes in comprehensive income would be allowable only on the basis of qualifying criteria related to an entity’s management intent/business model and the cash flow variability of the instrument Fair value changes for all instruments not meeting such criteria, including derivatives, equity securities and hybrid instruments would be required to be presented in net income. Interest and dividends, as well as credit impairments (see earlier discussion of FSP 115-2) and realized gains and losses, would continue to be presented in net income. Organizations will need to classify instruments at initial recognition, and subsequent reclassification would not be permitted.
While these decisions are certainly inconclusive and tentative, there do appear to be some inconsistencies when compared to the ED released by IASB; such inconsistencies can be expected to be reconciled by FASB and IASB as the groups continue working towards convergence. Primarily, FASB appears to prefer elimination of the amortized cost method of measurement, with minor exceptions, while IASB continues to see relevance in multiple measurement bases. Both bodies seem to recognize the concept of management’s intent”; FASB for purposes of determining the geography of unrealized gains and losses, while IASB’s ED would allow for measurement of certain instruments at amortized cost if management’s intent is other than trading. One notable consistency coming through is the likely elimination of impairment analyses for equity securities, given the proposals regarding presentation of fair value changes for such instruments.
A Final Thought
In case anyone in the financial reporting arena has been comfortable in recent years, be advised you should continue to hold onto your seats for the foreseeable future. We find ourselves in an environment where not only is the business landscape rapidly evolving (as it always has), but this economic crisis has instigated a level of political involvement that standard setters, financial statement preparers and users have not previously witnessed.Bifurcation of impairments, converging global standards and principles based guidance (just to name a few) will leave preparers, auditors, regulators and users facing an arduous learning curve. The changes coming our way will be served in the name of transparency and reduced complexity, but be assured it will feel anything but clear and simple!
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