Magazine article The CPA Journal

Practical Implications of Fair Value Hedges on Available-for-Sale Debt Securities

Magazine article The CPA Journal

Practical Implications of Fair Value Hedges on Available-for-Sale Debt Securities

Article excerpt

As the SEC considers requiring U.S. public companies to adopt International Financial Reporting Standards (IFRS) and International Accounting Standards (IAS) within the next few years, it's important to understand one crucial component of the change: how to implement a fair value hedge on availablefor-sale (AFS) debt securities. Guidance on this topic comes primarily from LAS 39, Financial Instruments: Recognition and Measurement. The standard classifies financial instruments into four categories. The categories identify the appropriate approach to measure the financial instruments. All financial instruments are recognized and measured at fair value initially. With the exception of loans, receivables, and held-to-rnaturity securities, which are measured at amortized cost all other financial instruments are measured at fair value in subsequent periods.

IAS 39, issued by the International Accounting Standards Board (IASB), can be compared in the United States to FASB's Statement of Financial Accounting Standards (SFAS) 115, Accounting for Certain Investments in Debt and Equity Securities. The two standards do not have the same principle on accounting for impairment however. When fair value falls below cost it is considered to be impaired or a permanent loss. Under SFAS 1 15, impairment occurs when the loss is considered to be other than temporary. IAS 39, on the other hand, recognizes an impairment loss under the incurred loss modeL in which an event must have triggered the loss. The loss is considered to have happened on the balance sheet date.

Though the computation of an impairment is similar, the accounting treatment is not the same. The impairment loss is recognized in the income statement by reversing the unrealized loss in the equity account. Under U.S. GAAP, the impairment is treated as an adjustment to the basis of the investment account. LAS 39 does not consider an impairment to have established a new cost basis. Hence, while U.S. GAAP requires the valuation allowance account to be reversed into the available-for-sale securities investment account IAS 39 retains the valuation account Nevertheless, both sets of standards appear to be congruent on the accounting for fair value hedges.

Fair Value

Fair value is utilized by accounting standards setters because of its relevance. Relevant information helps financial statement users predict tile outcome of future events, as well as confirm or correct prior expectations. Accounting standards provide a hierarchy for determining fair value.

Level 1 inputs are quoted prices of identical items in active markets. If those are not avadable, the next option is extrapolation from markets or sales. These could be quoted prices for similar assets or liabilities in active markets or reliable component cost markets. Level 2 inputs are derived principally from, or corroborated by, observable market data by correlation or other means. The last resort Level 3 inputs, are marked to model rather than marked to market:

Unobservable inputs shall reflect the reporting entity's own assumptions about the assumptions diat market participants would use in pricing the asset or liability (including assumptions about risk). Unobservable inputs shall be developed based on the best information available in the circumstances, which might include the reporting entity's own data. In developing unobservable inputs., the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. (SFAS 157, Fair Value Measurements, paragraph 30)

Available-for-sale debt securities are tiie most challenging category to account for. While the standard calls for measurement at fair value, the security is accounted for at amortized cost. A company is required to use a valuation allowance account to bridge the cost and fair value on the asset side and an unrealized gain or loss account on the equity side to account for the temporary change in toe market. …

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