Reporting Fair Value Interest and Value Changes on Financial Instruments

Abstract

AAA Financial Accounting Standards Committee INTRODUCTION The Joint Working Group of Standard Setters' (JWG 2000) Recommendations on Accounting for Financial Instruments and Similar Items (hereafter the Proposal) requires that all changes in the fair value of financial instruments be reported in the income statement, except those associated with certain foreign exchange transactions. The Proposal also requires that the interest and the gain or loss components of these changes in fair value be separately classified on the income statement, and it provides some guidance for calculating these components. Specifically, firms must record interest on a yield to maturity basis, with interest revenue (expense) on a financial asset (liability) being calculated as the current interest rate times the fair value of the instrument during the period. This approach differs from the current amortized cost accounting for interest. Assuming that the total changes in the fair value of financial instruments during the period are recognized in some fashion on the income statem ent, this difference in interest results in exactly the opposite difference in unrealized gains and losses. This commentary summarizes the position of the Financial Accounting Standards Committee of the American Accounting Association (hereafter the Committee) on the Proposal's fair value interest approach. (1) In particular, we compare the relative merits of the fair value and amortized cost approaches to interest. Our discussion assumes that the total changes in the fair value of financial instruments are recognized in some fashion on the income statement each period, so that the only issue is the classification of the components of those changes in fair value. The Committee is not aware of any empirical research that relates specifically to the relative desirability of the fair value and amortized cost approaches to measuring interest. However, empirical evidence supports the importance of reporting items separately with different sustainability and different certainty. By sustainability, we mean that an item persists over time, on average. A sustainable item could be uncertain, however, in that ex post its persistence may be higher or lower than expected. This evidence suggests that the preferred income statement reporting of the total periodic return to a financial instrument is to aggregate income components with similar sustainability and certainty. (2) Conceptually, the periodic returns to financial instruments can be separated into three components with distinct sustainability or certainty. The first two components- amortized cost interest and the difference between fair value interest and amortized cost interest--sum to fair value interest. It is useful to distinguish these two components of fair value interest because amortized cost interest is both sustainable and certain, whereas the difference between fair value interest and amortized cost interest is sustainable but uncertain. The difference between fair value interest and amortized cost interest is sustainable because unexpected changes in interest rates and the resulting unexpected changes in fair values affect fair value interest calculations throughout the remaining lives of financial instruments. For example, an unexpected gain on a financial asset due to a decrease in interest rates in the current period reduces expected fair value interest revenue on the asset throughout its remaining life. T he third component of the periodic returns to financial instruments is the unexpected change in their fair values during the period. Unexpected changes in the fair values of financial instruments are both unsustainable and uncertain. (3) The amortized cost interest method separately reports the first component--amortized cost interest--but combines the second and third components-the difference between fair value interest and amortized cost interest and the unexpected gain or loss. …