FAS 115-2: A Practical Analysis

Transcription

1 FAS 115-2: A Practical Analysis June 2009 Executive Summary The Financial Accounting Standards Board s (FASB) recent changes to its standards for mark-to-market accounting effective for reporting periods ending after June 15th, 2009 include a measure now compelling investors to re-evaluate their other-than-temporary impairment (OTTI) conclusions and make material changes in their accounting policies to ensure compliance. Amending OTTI guidance under U.S. generally accepted accounting principles (GAAP) for debt securities, the FASB Staff Position (FSP) FAS 115-2, Recognition and Presentation of Other-Than-Temporary Impairments 1, requires credit-related losses to be recognized in earnings, with remaining losses documented through Other Comprehensive Income (OCI). Intended to make the guidance more operational and to facilitate more transparent disclosure of OTTI in financial statements, the change was prompted by US Congressional passage of the Emergency Economic Stabilization Act in October of The mandates therein included, among other things, that the US Securities and Exchange Commission (SEC) conduct a study on mark-to-market accounting. 3 Subsequently, during hearings March 12, 2009, Congress requested the FASB review GAAP accounting rules, specifically mark-to-market and other-than-temporary impairment rules, leading to the FASB issuing its final FSPs April 2. 5 Directly applicable for interim and annual reporting periods ending after June 15, 2009, the directives of FAS in estimating credit losses may prove challenging for investors. This article is intended to provide a framework for understanding FAS and the process of recognizing income and loss in a manner that is consistent with the FSP. It assumes a common understanding of FAS and provides an analysis of the practical application of the pronouncement. 5 In addition to FAS and FAS 124-2, the FASB approved FAS (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) and FAS and APB 28-1 (Interim Disclosures about Fair Value of Financial Instruments). In its study issued Dec. 30, 2008, the SEC concluded not to suspend mark-to-market accounting, though stipulated, The current global economic crisis has highlighted difficulties in performing OTTI evaluations. 4 Furthermore, the SEC recommended that the FASB should evaluate the need for modifications (or the elimination) of current OTTI guidance to provide for a more uniform system of impairment testing standards for financial instruments. 1 FAS was introduced by the FASB on April 9, Signed into law by President George W. Bush, this legislation most notably created a $700 billion Troubled Assets Relief Program to purchase failing bank assets. 3 Emergency Economic Stabilization Act in October of 2008, Section 133: Required the SEC, in consultation with the Federal Reserve and the Treasury, to perform a study on mark-to-market accounting standards as provided in FAS 157, including the effects on balance sheets, impact on the quality of financial information, and other matters, and to report to Congress within 90 days on its findings. 4 Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting, US SEC, Dec

2 Introduction This article is the result of discussions conducted by Clearwater Analytics with current and prospective clients, auditors, and financial professionals regarding the interpretation and application of FAS The release of FAS reflects how accounting standards, compliance requirements, and perceptions evolve, especially in an economic downturn. FAS and FAS trace their lineage to FAS 115 1, issued by the FASB in 1993 to address accounting for and reporting on investments in equity securities that have readily determinable fair values, as well as investments in debt securities. In paragraph 16 of FAS 115, the FASB states if the decline in fair value is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value as a new cost basis and the amount of the write-down shall be accounted for in earnings (that is, accounted for as a realized loss). This phrase quickly sparked debate surrounding the interpretation and application of otherthan-temporary [impairment]. 2 As companies began implementing Statement 115, more guidance was needed to assist their auditors in assessments of OTTI-relevant assets. As a result, the Emerging Issues Task Force (EITF) 3 published guidance 4 for determining the meaning of OTTI and its application to debt and equity securities within the scope of Statement 115 and FAS 124 Accounting for Certain Investments Held by Not-for-Profit Organizations. 5 1 FAS 115, Accounting for Certain Investments in Debt and Equity Securities, FASB, May 1993 Setting forth a daunting list of impairment indicators for auditors to identify OTTI when analyzing a portfolio, EITF 03-1 fostered confusion in the impairment process. Determined to simplify its guidance on the impairment process, the FASB issued FAS 115-1, replacing most of the guidance offered in EITF 03-1 and creating a more principles-based approach to the impairment process, rather than the rules-based approach established in EITF In this next phase of evolution of OTTI accounting, designed to make the guidance more operational, FAS applies specifically to debt securities. Previously, in order for an impairment to not be considered other-than-temporary, investors had to assert ability and intent to hold the security for a period of time sufficient to allow for a recovery of the fair market value to its amortized cost. 6 Under the new guidance, investors now have to assert that they (1) do not have the intent to sell the security and (2) it is likely the security will not have to be sold prior to the security s market value returning to its amortized cost. If investors intend to sell the security or will likely 7 be required to sell the security, they should realize a loss equal to the full difference between the amortized cost and fair market value in earnings. Even if investors are able to assert that they do not have the intent to sell, 8 and are not likely to be required to sell, they cannot assert that they will be able to hold the security to a recovery of the amortized cost if the present value of future expected cash flows is less than the amortized cost. This will result in an OTTI. Investors must then determine what portion of the impairment is due to a credit loss (the difference between the present value of future expected cash flows and amortized cost). Investors must then realize a loss (equal to the total credit loss) through earnings and recognize the remaining portion of impairment through OCI. Process for Evaluating/ Handling Securities FAS established a three-step process to evaluate and handle securities with otherthan-temporary impairments. This process encompasses: 1. Determine Whether an Investment is Impaired 2. Evaluate Whether an Impairment is Other Than Temporary 3. If the Impairment is Other Than Temporary, Recognize an Impairment Loss Equal to the Difference between the Investment s Cost and Its Fair Value Moving beyond the FAS guidelines, the high-level steps (identify, evaluate, recognize) applied by are not that different. The first step to identify the impaired securities is to evaluate if the fair value of a debt security is less than its amortized cost basis at the balance sheet date This guidance lists a number of aspects included in the calculation of amortized cost, including adjustments for accretion, amortization, collection of cash, previous OTTIs recognized in earnings, and fair-value hedge accounting adjustments. 2 For more details, see: FAS A Practical Analysis, Clearwater Analytics - Treasury Topics, Jan Formed in 1984 by the FASB to provide assistance with timely financial reporting. The EITF holds public meetings in order to identify and resolve accounting issues occurring in the financial world. 4 EITF 03-1 The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, EITF, Oct For more details, see: FAS A Thought Framework on Impairment and the Organizational Policy, Clearwater Analytics - Treasury Topics, Dec Actual language of FAS 115-2: more likely than not will not be required to sell the security prior to its anticipated recovery. 7 Actual language in FAS 115-2: or more likely than not 8 Actual language in FAS 115-2: and more likely than not will not be required to sell 9 FAS 115-2, Paragraph 19

3 The next step is to determine whether the impairment is other-than-temporary. Previously, investors could avoid classifying an impairment as other-than-temporary by asserting the ability and intent to hold the security until a fair-market value return to its amortized cost. The FASB modified its guidance for debt securities to be more operational in certain scenarios, including: Scenario 1: If investors have the intent to sell the security, an OTTI has occurred. Scenario 2: If investors will more likely than not be required to sell the security prior to recovery of a security s market value to its amortized cost, an OTTI has occurred. This may be due to cash flow requirements or contractual or regulatory obligations. Figure 1: Investor Decision Tree Equity Securities Ability & Intent to Hold to Cannot Assert Ability or Intent to Hold to Impaired Intent to Sell Total Portfolio Debt Securities Likely Required to Sell Before Realize Difference Between Amortized Cost & Fair Market Value In Net Income (Earnings) No Credit Loss Exists Credit Loss Exists Not Impaired Change in Fair Market Value Recognized in Other Comprehensive Income Credit Loss Realized in Earnings (Net Income) Remaining Portion of Impairment Recognized in Other Comprehensive Income Scenario 3: If investors do not expect to recover the entire amortized cost basis of the security meaning that the present value of future expected cash flows is less than the amortized cost an OTTI has occurred. The first two scenarios are situations that investors can quickly determine. An intentto-sell would be clear if there were a trade in progress, if the investor were actively seeking a buyer for the security, or if the investor had requested that their security be sold. Determining whether investors would likely be required to sell 1 the security depends on multiple factors, including contractual or regulatory obligations and business cash-flow needs. If either situation exists, they should recognize a loss in earnings equal to the difference between the security s fair-market value and its amortized cost. The third scenario requires investors to consider a broad range of factors in order to determine if a credit loss exists, encompassing the length and duration of the credit loss; historic and implied volatility; payment structure of the security and the likelihood of the issuer being able to make required payments; defaults; changes in credit rating 1 Actual language in FAS 115-2: will more likely than not be required to sell by various rating agencies; and performance since the report close date. If after an analysis of these factors, investors determine that a credit loss exists, they must calculate the portion of the impairment due to the credit loss. This is done by subtracting the best estimate of the present value of cash flows expected to be collected from the debt security from the security s amortized cost. This amount should be recognized as a loss in earnings. They should also recognize the amount of the impairment due to all other factors in OCI. The income statement should show the total impairment with an offset for the amount recognized in OCI, similar to this example. Figure 1 (above) presents a typical investor decision tree when considering other-thantemporary impairment. After investors recognize an OTTI in any of these scenarios, the amortized cost of the security should be the previous amortized cost, less the amount that has been recognized in earnings. Investors should accrete the difference between the new amortized cost and the cash flows expected to be collected. Additionally, investors should continue to estimate the present value of future cash flows. They should account for a significant increase in future expected cash flows, or cash flows actually received as a prospective adjustment to the remaining total amount of expected accretion (accretable yield). 2 2 FAS 115-2, Paragraph 32: Debt securities accounted for under EITF Issue should follow that guidance for changes in cash flows expected to be collected. For all other debt securities, an increase in future expected or actually received cash flows should be accounted for as a prospective adjustment to the accretable yield in accordance with SOP 03-3, even if the debt security would not otherwise be within the scope of that standard.

4 Cumulative Effect Adjustment Post June 15, 2009, investors should recognize a cumulative effect adjustment on those securities that they hold, that they do not intend to sell, and that they will not likely be required to sell 1 before the security s market price returns to its amortized cost. Investors should determine the cumulative effect adjustment by subtracting the present value of future cash flows from the security s amortized cost and should also consider any tax effects. This cumulative effect adjustment should affect retained earnings and accumulated OCI. The amortized cost should be adjusted for the cumulative effect adjustment amount before taxes. Disclosure The disclosures required by FAS were previously requisite on annual reports, but not on quarterly reports. This statement requires that these disclosures now be included in the quarterly reports as well. There should also be additional disclosures explaining the methodologies and inputs used to determine the amount of credit loss on securities that had a portion of the impairment recognized in earnings. Application Figure 2 depicts the life of an other-thantemporarily impaired lot. In this example, the bond was purchased at a premium. The amortization schedule used par and an effective maturity date at the end of 2010 as the target end point. By the end of 2008 the bond was impaired (the market price was less than the amortized price) and the investor determined that the impairment was other than temporary. Under FAS the requirements at that time the investor realized the full impairment through 1 Actual language in FAS 115-2: will more likely than not be required to sell Total Other-Than-Temporary Impairment (OTTI) losses...($10,000) Portion of loss recognized in other comprehensive income (before taxes)...$4,000 Net impairment losses recognized in earnings...($6,000) Figure 2: An Other-Than-Temporarily Impaired Lot earnings (net income), and the bond s market value became the new amortized cost. The investor adjusted the bond s amortization schedule from the write-down price to par and from the write-down date to final maturity. The investor adopted FAS in the second quarter of 2009 and recognized the cumulative effect adjustment at that time. By the end of 2009, the investor determined that this bond had a credit loss. The value of the future expected cash flows was $85 and the present valuation of those future expected cash flows was $80. The investor realized a loss equal to the difference between the bond s amortized cost and $80. The investor recognized the remaining impairment the difference between $80 and the fair market value in other comprehensive income. The difference between the future expected cash flows and the present value of the future expected cash flows ($85-$80) determines the total amount to be recognized through accretion over the remaining life of the bond. Additional Thoughts One of the stated goals of the FAS pronouncement was to make the OTTI guidance more operational. 2 In some ways, this was successful. For instance, it is easier to support the conclusion that there is no intent to sell a lot. It is also less problematic to provide supporting evidence that it is not likely 3 that the security will be sold before recovery than it is to support the ability and intent to hold a security to recovery. However, FAS introduces a significant number of new data points 4 for investors to track, and analyze for each of their securities. This has the potential of creating a significant amount of work for accounting organizations that are suffering with constrained resources. 2 FAS 115-2, Paragraph 2 3 Actual language in FAS 115-2: is not more likely than not 4 FAS 115-2, Paragraph 25

5 Additionally, there are a number of required calculations and analyses that many investors have not had to perform previously. Investors who have been subject to EITF or SOP 03-3 have already been required to perform future expected cash flow analysis in their reporting. FAS extends the cash flow analysis obligation to a much larger number of investors. Depending on the complexity and type of security, this can be a formidable task. Securities with any type of optionality will require the most work. This additional work may have unintended consequences as investors trade off the burden of reporting with the benefit of holding the security in their portfolio. Many may choose to exit their positions and buy other security types with less onerous reporting requirements. Conclusion Clearwater recommends investors proactively develop and endorse a process that responds to FAS in a way that will satisfy their auditors. Ultimately, this statement enables investors to avoid realizing losses beyond the value that they expect to lose over the life of the security. Further Reading As FAS expands the guidance of FAS 115-1, Clearwater Analytics recommends its clients be familiar with FAS 115 and Clearwater Analytics has two white papers that provide analysis and guidance: FAS A Thought Framework on Impairment and the Organizational Policy and FAS A Practical Analysis Both documents are available for download online. Clearwater Analytics closely monitors FASB proclamations and interprets ramifications, providing a range of guidance (incl. Free Consultations, White Papers, Training, Alerts, Links to Industry Resources, and more) easily accessible at com/resources/education.asp. DISCLAIMER The information provided in this article is the result of experience with investment accounting issues and interaction with accountants and investment service providers. It is not intended to be relied upon substantively; rather, it is intended to inform and provide a discussion framework that treasury practitioners, internal management, and accounting and audit staff can use to discuss the impairment process. About Clearwater OUR LOCATIONS HEADQUARTERS 950 Bannock Street Suite 1050 Boise, ID PH: NEW YORK OFFICE 88 Pine Street, 7th Floor New York, NY PH: US SALES Sales@clearwateranalytics.com GENERAL INQUIRY Info@clearwateranalytics.com Clearwater provides web-based, investment portfolio reporting and analytics for institutional investors, investment managers, custody banks, and electronic trading portals. With solutions for both separately-managed and commingled accounts, Clearwater delivers the highest level of portfolio transparency available on the market today for clients such as Cisco, Oracle, Starbucks and Yahoo! Launched in 2004, with offices in New York and Boise, Idaho, Clearwater reports on more than $650 billion in assets for 4,500 institutional investors Clearwater Analytics All rights reserved. This material is for informational purposes only. Clearwater makes no warranties, expressed or implied, in this summary. All technologies described herein are either registered trademarks or trademarks of their respective owners in the United States and/or other countries.