There is no handout for this discussion.

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1 Board Meeting Handout Accounting for Financial Instruments: Impairment August 1, 2012 There is no handout for this discussion. The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

2 Board Meeting Handout Accounting for Financial Instruments: Classification and Measurement August 1, 2012 Purpose of This Meeting 1. The Board will discuss the following three issues related to the classification and measurement of financial instruments: (a) (b) (c) Issue 1: Evaluation of a valuation allowance on a deferred tax asset related to a debt instrument for which qualifying changes in fair value are recognized in other comprehensive income (FV-OCI) Issue 2: Recognition and measurement of foreign currency gains and losses on foreign currency denominated debt securities classified at FV- OCI Issue 3: Presentation of debt instruments that qualify for the amortized cost classification at initial recognition and are subsequently identified for sale. Issue 1 Evaluation of a Valuation Allowance on a Deferred Tax Asset Related to a Debt Instrument for Which Qualifying Changes Are Recognized in FV-OCI 1. This issue discusses the feedback received on the FASB s May 2010 proposed Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, regarding the evaluation of a valuation allowance on a deferred tax asset related to a debt instrument for which qualifying changes in fair value are recognized in FV-OCI. Stakeholders largely disagreed with the proposal to evaluate the need for a valuation allowance on a deferred tax asset related to a debt instrument classified and measured at FV-OCI in The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

3 combination with an entity s other deferred tax assets (rather than segregated and analyzed separately). Generally, stakeholders noted that questions about the application of the guidance in FASB Accounting Standards Codification Topic 740 should be considered in a comprehensive project on income taxes. Question 1 for the Board 1) Does the Board wish to include guidance on the evaluation of the allowance for a deferred tax asset as part of the financial instruments project? Issue 2 Recognition of Foreign Currency Gains and Losses on Foreign Currency Denominated Debt Securities Classified at FV-OCI 2. This issue discusses the manner in which to recognize foreign currency gains and losses on foreign currency denominated debt securities classified at FV-OCI. The staff proposes the following alternatives: (a) (b) Alternative 1: Foreign currency gains and losses on foreign currency denominated debt securities classified at FV-OCI would be recognized in earnings. Alternative 2: Foreign currency gains and losses on foreign currency denominated debt securities classified at FV-OCI would be recognized in other comprehensive income (consistent with existing U.S. GAAP). Question 2 for the Board 2) Which alternative does the Board prefer related to the accounting for foreign currency gains and losses for foreign currency denominated debt instruments classified at FV-OCI? 2

4 Issue 3 Presentation of Debt Instruments Subsequently Identified for Sale 3. This issue discusses the manner in which debt instruments that qualify for the amortized cost category at initial recognition and are subsequently identified for sale should be presented. The staff proposes the following alternatives. (a) (b) Alternative 1: Disaggregate debt instruments subsequently identified for sale from debt instruments held for the collection of contractual cash flows and present them as a separate line item on the balance sheet. Alternative 2: Present on the face of the balance sheet a total for the amortized cost balance for debt instruments classified at amortized cost with a separate line item showing the total allowance and provide a tabular disclosure in the notes to the financial statements that shows the cost basis and the allowance associated with debt instruments classified as held for collection and those identified for sale (subsequent to initial recognition). 4. Both alternatives also would require an entity to disclose in the notes to the financial statements why it decided to depart from its held-for-collection business model with regard to those instruments. Additionally, for debt instruments that were held for collection at initial recognition but were subsequently sold during the reporting period, both alternatives would require the entity to disclose the amortized cost, fair value, and the resulting gain or loss recognized on the sale of such instruments during the reporting period. Question 3 for the Board 3) Which alternative does the Board prefer for the presentation of debt instruments initially measured at amortized cost that are subsequently identified for sale? 3

5 Board Meeting Handout Repurchase Agreements and Similar Transactions August 1, 2012 Purpose of This Meeting 1. At the June 27, 2012 Board meeting, the Board discussed the accounting for repurchase agreements involving the sale and repurchase of identical financial assets having the following characteristics and decided that those transactions would be accounted for as secured borrowings. (a) (b) (c) (d) (e) (f) They involve a transfer of existing financial assets at the inception of the arrangement (that is, the financial assets to be transferred and repurchased are pre-identified and recognized on the transferor s balance sheet at the inception of the arrangement). The agreement involves both a right and obligation to repurchase the financial assets (that is, a forward contract). The initial transfer and forward repurchase agreement involve the same counterparty. The agreement to repurchase the financial assets is entered into contemporaneously or in contemplation of, the initial transfer. The repurchase price is fixed or readily determinable. The financial assets specified under the forward repurchase agreement are identical to the assets initially transferred. 2. This decision creates an exception to the derecognition guidance in FASB Accounting Standards Codification Topic The purpose of this meeting is to (a) address whether that exception should be expanded to repurchase agreements with those same characteristics, except that The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

6 they involve the sale and repurchase of similar, but not identical, financial assets and (b) address the accounting for repurchase agreements and similar transactions that do not meet one or more of the specified characteristics that would define the population of transactions required to apply secured borrowing accounting. Issues for Discussion and Alternatives Topic A Accounting for repurchase agreements involving a sale and repurchase of similar financial assets 4. Issue 1: Whether to require secured borrowing accounting for certain repurchase agreements involving financial assets that are similar (or substantially the same), consistent with the tentative decision for repurchase agreements involving identical assets. (a) (b) Alternative 1: Limit the exception requiring secured borrowing accounting only to repurchase agreements with the characteristics in paragraph 1 that involve a sale and repurchase of identical financial assets. Alternative 2: Extend the exception requiring secured borrowing accounting to repurchase agreements with the characteristics in paragraph 1 that involve similar, but not identical, financial assets if the financial assets to be purchased are substantially the same as the financial assets initially transferred. 5. Issue 2: If the approach under Issue 1 is to require secured borrowing accounting for repurchase agreements involving substantially the same financial assets, whether any changes to the existing criteria defining the term substantially the same in Codification paragraph (a) are needed. (a) Alternative 1: Retain the requirement that the financial assets to be purchased are substantially the same as the financial assets initially transferred. However, eliminate the detailed criteria for determining 2

7 whether the financial asset to be repurchased is substantially the same as the asset transferred. (b) (c) Alternative 2: Retain the existing criteria for determining whether the financial asset to be repurchased is substantially the same as the asset transferred, but with clarifications. Alternative 3: Retain the existing criteria with no change. Topic B Application of derecognition guidance to repurchase agreements and similar transactions that do not meet all of the criteria for the secured borrowing exception 6. Issue 1: How to account for repurchase agreements and similar transactions that do not meet one or more of the specified characteristics that would define the population of transactions required to apply secured borrowing accounting. (a) (b) Alternative 1: Evaluate under existing derecognition conditions in Codification paragraph all transactions that do not meet one or more of the characteristics that define repurchase agreements that are required to apply secured borrowing accounting. Alternative 2: Account for all transactions that do not meet one or more of the characteristics that define repurchase agreements that are required to apply secured borrowing accounting as sale transactions with forward purchase commitments. 7. Issue 2: If the approach under Issue 1 that requires that transactions that do not meet one or more of the characteristics defining repurchase agreements that are required to apply secured borrowing accounting be evaluated under existing derecognition conditions in Codification paragraph is selected, whether the application of the isolation condition to repurchase agreements should be clarified. (a) Alternative 1: Clarify the application of the isolation condition to arrangements that are not subject to the exception requiring secured borrowing accounting. 3

8 (b) Alternative 2: Do not clarify the application of the isolation condition to arrangements that are not subject to the exception requiring secured borrowing accounting. Questions for the Board 1) Topic A, Issue 1: What alternative is preferred for accounting for repurchase agreements that involve substantially the same financial assets? 2) Topic A, Issue 2: If Alternative 2 under Issue 1 is selected, should the substantially the same criteria be eliminated, refined, or retained without change? 3) Topic B, Issue 1: What should be the approach to accounting for repurchase agreements and similar transactions that are not subject to the exception requiring secured borrowing accounting? 4) Topic B, Issue 2: If Alternative 1 under Issue 1 is selected, should the application of the isolation condition for these transactions be clarified? 4

9 Board Meeting Handout Insurance Contracts August 1, 2012 PURPOSE OF THE MEETING 1. The purpose of this meeting is to discuss whether charitable gift annuities issued by not-for-profit entities meet the definition of insurance and would, therefore, fall within the scope of the proposed insurance contracts standard. The Board will also discuss the accounting for the expected contribution component. Issue 1: Charitable Gift Annuities Whether There Should Be an Explicit Scope Exception Background 2. A charitable gift annuity is a contract under which a not-for-profit organization, in return for a transfer of assets, is obligated to make periodic stipulated payments to the donor or a third-party beneficiary for a specified period of time, usually either a specified number of years or until the death of the donor or third-party beneficiary. Current Accounting for Charitable Gift Annuities 3. The not-for-profit recognizes assets for the fair value of the consideration contributed and a liability for the present value of the future payments to be made to the annuity contract holder (that is, expected annuity payments). The excess of assets over the liability is recognized as contribution revenue. That portion can be seen as analogous to the expected profit or a single margin under insurance contracts accounting. At each reporting date, the assumptions used in the liability measurement are revised to reflect current market conditions, other than the discount rate that is locked in at contract inception unless the fair value option has been elected. The tentative decisions in the insurance contracts project will require all assumptions to be updated each reporting period. The staff prepares Board meeting handouts to facilitate the audience's understanding of the issues to be addressed at the Board meeting. This material is presented for discussion purposes only; it is not intended to reflect the views of the FASB or its staff. Official positions of the FASB are determined only after extensive due process and deliberations.

10 Regulation of Charitable Gift Annuities 4. In an effort to prevent competitive rate setting between not-for-profit organizations for donation funds thereby ensuring that a significant portion of the transfer is available for charitable purposes the American Council on Gift Annuities was established in 1927 to set suggested maximum rates of return that charitable gift annuities should pay to the annuitant/beneficiary. The American Council on Gift Annuities rates take into account current mortality tables and the Internal Revenue Service discount rate for charitable deduction calculations, which is set monthly, based on a survey of interest rates for various financial instruments. However, American Council on Gift Annuities rates are suggested maximum rates and are not required. 5. Additionally, to qualify for preferential tax treatment, IRC 514(c)(5)(A) dictates that a charitable gift annuity must have a charitable value that is more than 10 percent of the funding amount. Otherwise, the annuity may constitute commercialtype insurance and will not qualify as a charitable gift annuity for tax purposes, which may give rise to unrelated business taxable income. Staff Analysis 6. One of the FASB s desired improvements in its project on insurance contracts is that regardless of the issuing entity, contracts that transfer significant insurance risk and contain similar economic characteristics should be accounted for in a similar manner. a. Annuities are a type of insurance contract that meet the definition of insurance from the proposed insurance contracts guidance, which is a contract under which one party accepts significant insurance risk from another party by agreeing to compensate the policyholder if a specified uncertain future event adversely affects the policyholder. b. A contract does not transfer significant insurance risk if there is no scenario that has commercial substance in which the insurer can suffer a loss, with 2

11 loss defined as an excess of the present value of the cash outflows over the present value of the premiums. c. An insurer should consider the time value of money in assessing whether the additional benefits payable in any scenario are significant. 7. Charitable gift annuities would, in many cases meet the definition of insurance, albeit some of the contracts may be written such that the chance of loss is nil. Based on discussions with preparers, it is rare for a charitable gift annuity to be a loss to the not-for-profit, however, it does occur. Those preparers noted that it is not uncommon for the ultimate contribution to be less than initially expected and potentially nil, which is occurring more frequently as people live longer and investment returns remain low. That is consistent with the results for commercial insurers. 8. Despite the American Council on Gift Annuities-capped annuity rates and the Internal Revenue Service donation element requirements, a low likelihood may still exist that a contract may be loss generating due to a combination of longevity risk and investment risk. Therefore, the staff notes that charitable gift annuities do meet the technical definition of possessing significant insurance risk because there could be a scenario that has commercial substance in which the insurer can suffer a loss. Question 1 Definition of Insurance 1. Does the Board agree that charitable gift annuities contain an element of insurance risk that meets the definition of insurance and should be required to apply the insurance contracts guidance for measuring the insurance contract liability? 3

12 Issue 2: Charitable Gift Annuities Accounting for the Expected Contribution Comparison of Not-for-Profit and Insurance Accounting 9. The staff notes that not-for-profits are currently presenting either on the face of the financial statements or in note disclosures many aspects of the proposed insurance contracts guidance, for example: a. Both use actuarial mortality tables. b. Both discount the liability at a rate that is meant to be commensurate with the risks involved. 10. However, some of the major areas that may change to implement the proposed insurance contracts guidance include the following: a. The proposed insurance model does not include a risk adjustment on top of the measurement of the liability, which not-for-profits are required to include. b. The difference between the consideration received and the measurement of the liability is recorded as contribution revenue under not-for-profits, whereas it is deferred under the insurance contracts model until the uncertainty in the cash flows is released (that is, no day one gain). 11. Because charitable gift annuities meet the definition of insurance, the staff notes that the measurement (that is, present value of the expected cash flows) of the liability should be the same regardless of the entity issuing the contract. Alternative Treatments 12. The staff notes that there are three alternatives that should be considered for the treatment of charitable gift annuities issued by not-for-profits. 4

13 Alternative A 13. Measure the insurance liability under the proposed insurance contract s building block approach essentially treating it as a commercial annuity. This would include deferring all day one revenues or gains. a. Just as the insurers profit is at risk, the not-for-profit s contribution amount is at risk. The not-for-profit may realize significantly more or less contribution depending on a myriad of factors including age of death, investment returns, and interest and discount rates. b. Therefore, some argue that the contribution recognized by a not-for-profit should be recognized over time because the uncertainty in the ultimate contribution amount becomes more certain. c. Many would argue that this is unnecessarily conservative because contribution revenue should be recognized for the donation element at the date of gift in accordance with current U.S. generally accepted accounting principles (GAAP) and the underlying principle for recognition of gifts. That is especially true when taking into account the low probability that a charitable gift annuity would be loss generating. Alternative B 14. Measure the insurance liability under the proposed insurance contract s building block approach and recognize all day one gains as contribution revenue on the effective date of the contract per current not-for-profit guidance. a. Under this approach, the view is that the transfer of assets less the expected payout constitutes a donation. Therefore, the entire difference in expected outflows from expected inflows would be recognized as contribution revenue on the day of the transfer consistent with not-for-profit-gifting guidance. However, the annuity obligation would be measured the same had it been issued by a nonnot-for-profit. b. This approach, however, could be seen as oversimplifying the economics of the transaction because it ignores the insurance element of the charitable gift annuity (that is, the uncertainty in the cash flows). 5

14 Alternative C 15. Unbundle the insurance and donation components of the charitable gift annuity and account for them under their applicable standards (this is, insurance in accordance with the proposed insurance contracts standard and the donation component in accordance with the accounting for gifts guidance). That would include recognizing the donation component as contribution revenue on day one and deferring any day one gains on the insurance component until the entity is released from risk. 16. The concept of distinct components from other unbundling decisions could be used to determine whether there are two components. A donor could separately purchase a commercial annuity and make a donation to a not-for-profit. The not-for-profit has to perform (that is, provide insurance that includes the task of paying the claims) for the annuity component while there is nothing the not-for-profit has to do for the donation component. 17. A not-for-profit would determine the amount of consideration that it would charge for the insurance performance obligation using tentative decisions on allocating the consideration based on a relative stand-alone selling price basis. a. The difference between the consideration paid to the not-for-profit and the amount allocated to the insurance component would be considered the donation and recognized as contribution revenue when received. b. The difference between the consideration allocated to the insurance component and the measurement of the liability would be deferred and recognized as the entity is released from risk. 18. The following is a simplified example (that is, ignores time value of money) to illustrate the alternative treatments: a. A donor transfers $50,000 to a not-for-profit entity that agrees to pay the beneficiary/annuitant $300 per month for the remainder of his/her life. 6

15 b. The same person can find a commercial annuity with the same $300 per month payout rate for a cost of $40,000, in the form of a one-time premium. c. The present value of the expected payout on the annuity is $36, Summary Results of Alternatives: Current U.S. Alternative A Alternative B Alternative C GAAP for CGAs Day 1 Transferred Amount 50,000 50,000 50,000 50,000 Price for comparable commercial annuity NA NA NA 40,000 Annuity Payment Liability (PV) 1 36,000 36,000 36,000 36,000 Deferred Margin - 14,000-4,000 Contribution 14,000-14,000 10,000 Future Periods Future Contribution - 14,000-4,000 Total Contribution 14,000 14,000 14,000 14, The staff recommends Alternative C above and that the following guidance be incorporated into the not-for-profit accounting guidance. a. If a contribution contains a distinct performance obligation that meets the definition of insurance, that performance obligation should be accounted for in accordance with the proposed insurance contracts standard. b. Entities should allocate the transaction price to the separate insurance performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying the separate insurance performance obligation. (1) To allocate an appropriate amount of consideration to the separate insurance performance obligation, an entity should determine the stand-alone selling 1 The annuity payment liability may be different under the insurance contracts liability as a result of using different discount rate or other assumptions. 7

16 price 2 at contract inception of the underlying insurance performance obligation and allocate the transaction price on a relative stand-alone selling price basis. (2) Account for the insurance component in accordance with the guidance in the insurance contracts project. c. Entities should allocate the difference between the total consideration and the amount allocated to the insurance component to the donation. That donation element will continue to follow the not-for-profit guidance for gifts. d. Under this recommendation only the measurement of the insurance liability would be impacted; all other elements of not-for-profit reporting would be retained. For example: (1) Not-for-profits do not recognize premium in their financial statements, rather, they only record the amount of expected contribution. 3 (2) The impact from the change in assumptions, including the discount rate, would be recorded to the Statement of Activities. 4 That is consistent with the adoption of Subtopic , Compensation Retirement Benefits Defined Benefit Plans General, for not-for-profits that includes guidance that states that a business entity that is not required to report other comprehensive income pursuant to Subtopic , Comprehensive Income Overall, shall apply the provisions of in an analogous manner that is appropriate for its method of financial reporting. 2 This is defined in proposed FASB Accounting Standards Update, Revenue Recognition (Topic 605): Revenue from Contract with Customers, as the price at which an entity would sell a promised good or service separately to a customer. 3 This would be similar to the margin approach proposed in the IASB Exposure Draft, Insurance Contracts. In addition, the Board tentatively decided that (a) an investment component is an amount that the insurer is obligated to pay the policyholder or a beneficiary regardless of whether an insured event occurs and (b) an amount attributed to the investment component should be excluded from the statement of comprehensive income. 4 The Board tentatively decided to require insurers to record the impact from changes in the discount rate to other comprehensive income.. The staff intends on bringing a paper to the Boards regarding participating contracts and other situations in which requiring other comprehensive income may not be appropriate. 8

17 (3) Fundraising costs would be expensed as incurred The staff considered costs and operational implications of implementation of the proposed insurance contracts standard by not-for-profits. a. Present value of expected cash flows (that is, building blocks one and two): Minimal operational implications are likely since most requisite financial reporting information and measurement information is currently provided. Not-for-profits are already performing the calculations necessary to measure the annuity payment liability using actuarial assumptions; however, there could be changes to some of the assumptions used in the measurement of the liability. Additionally, not for profits are already disclosing much of the information that would be required under the proposed insurance contract standard for annuity contracts. b. Single margin (that is, building block three): This would require an additional step in that the not-for-profit would need to determine the amount of premium that an insurance entity would charge for a single premium immediate annuity that pays out the amount agreed to in the charitable gift annuity. Based on the staff s limited outreach, it is feasible to obtain premium prices from commercial insurers. In addition, the not-for-profit would need to implement a process to release the single margin based on the release from risk as reflected by a reduction in the uncertainty of the expected cash flows. 22. The staff believes that Alternative C is the most accurate reflection of the economics of the transaction. 5 The majority, if not all fundraising costs, would be considered solicitation and would be required to be expensed as incurred under the tentative decisions in the insurance contracts project. 9

18 Question 2 2. Does the Board agree with the staff recommendation that not-for-profit entities allocate the total consideration between the insurance and donation components? Specifically, the following: a. If a contribution contains a distinct performance obligation that meets the definition of insurance, that performance obligation should be accounted for in accordance with the proposed insurance contracts standard. b. The not-for-profit allocates the transaction price to the separate insurance performance obligation in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for satisfying the separate insurance performance obligation. (1) To allocate an appropriate amount of consideration to the separate insurance performance obligation, an entity should determine the standalone selling price at contract inception of the underlying insurance performance obligation and allocate the transaction price on a relative stand-alone selling price basis. (2) Account for the insurance component in accordance with the guidance in the insurance contracts project. c. The not-for-profit allocates the difference between the total consideration and the amount allocated to the insurance component to the donation. That donation element will continue to follow the not-for-profit guidance for gifts. 10