Volume 22, No. 3: Financial Instruments Accounting: Back To The Drawing Board

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In December 2012, the FASB issued an exposure draft on financial instruments accounting – its third one in less than three years. First was the ill-fated “all financial instruments at fair value” proposal in 2010; second, the since-abandoned “three-buckets-of-entropy” model developed jointly with the IASB. The IASB continues to labor on that particular model. In FASB’s third whack at revamping financial instruments accounting, it tees up a “current expected credit loss” model, one that breaks from current practice by requiring an amortized cost basis for financial instruments to incorporate forward expectations of losses in setting the loan loss allowance. “Forward expectations” have always been off-limits in constructing credit loss allowances.

Is the third time the charm? The jump from drawing board to final standard just might happen in 2013; even if it does, the new standard might not be effective for several years. It’s not a perfect solution. Here, we’ll take a look at why it might bulk up loan loss allowances – something investors perceive as good behavior – while affording managers increased discre-tion to manage their firm’s earnings. That’s something investors perceive as bad behavior. A look at fair value disclosures already provided to investors shows how investors can improve their evaluation of balance sheet quality while they wait for the new standard to emerge.

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