Financial instruments: FASB standard on recognition and measurement

Transcription

1 Financial instruments: FASB standard on recognition and measurement Prepared by: Faye Miller, Partner, National Professional Standards Group, RSM US LLP Updated April 2018 Overview On January 5, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) , Financial Instruments Overall (Subtopic ): Recognition and Measurement of Financial Assets and Financial Liabilities, its long-awaited final standard on the recognition and measurement of financial instruments. ASU applies to all entities that hold financial assets or owe financial liabilities and was subsequently clarified with the recent issuance of ASU , Technical Corrections and Improvements to Financial Instruments Overall (Subtopic ): Recognition and Measurement of Financial Assets and Financial Liabilities. The discussion that follows summarizes the significant changes ASU (as clarified by ASU ) brought about to existing guidance, outlines the effective date and transition provisions and discusses how to plan ahead for implementation. It concludes with a discussion on convergence and a chart that provides a comparison of current U.S. generally accepted accounting principles (GAAP) to ASU and International Financial Reporting Standard (IFRS) 9, Financial Instruments. While ASU is not first effective until 2018 for calendar year public business entities (PBEs), certain provisions can be adopted early. Middle market insights We believe the most far-reaching ramification of ASU is the elimination of the available-for-sale (AFS) classification for equity securities and the requirement to carry most equity securities at fair value through net income. This will likely result in significant income statement volatility for middle market companies that hold equity securities. Summary of significant changes The following areas were affected by ASU , and will be explained in the discussion that follows: Measurement of equity securities Valuation allowance for deferred tax assets associated with AFS debt securities Recognition of changes in fair value of liabilities attributable to instrument-specific credit risk Financial instrument disclosure requirements

2 Measurement of equity securities ASU created Subtopic , Investments Equity Securities, of the FASB s Accounting Standards Codification (ASC), which is applicable to all entities except those in industries that account for substantially all investments at fair value through earnings or the change in net assets, such as broker-dealers, investment companies and postretirement plans. Along with the creation of the new subtopic, ASU eliminates the existing equity securities guidance contained within ASC , Investments Debt and Equity Securities Overall, including the AFS classification and the guidance related to cost method investments in ASC , Investments Other Overall. As such, it is no longer permissible to carry equity securities at fair value through other comprehensive income (OCI) or to apply the cost method to those equity securities that do not have readily determinable fair values. Under this new subtopic, equity securities are generally required to be measured at fair value with unrealized holding gains and losses reflected in net income. Understanding what constitutes an equity security that is subject to ASC Equity securities are defined to include: (a) preferred, common and other ownership interests in entities, including partnerships, joint ventures and limited liability companies and (b) rights to acquire or dispose of ownership interests in entities at fixed or determinable prices. It should be noted that investments in mutual funds or ownership interests in companies or partnerships are considered to be equity securities even if the assets of the investee consist solely of debt securities given that, as indicated in ASC , it is not appropriate to look through the form of the investment. The definition of equity securities excludes certain options, as well as convertible debt and preferred stock that, by its contractual terms, must be redeemed by the issuing entity or is redeemable at the investor s option. Additionally, certain equity securities are excluded from the scope of ASC , namely: Derivative instruments subject to ASC 815, Derivatives and Hedging Equity investments that result in consolidation of the investee or are accounted for in accordance with the equity method of accounting under ASC 323, Investments Equity Method and Joint Ventures Broker-dealer ownership interests in exchanges as described in ASC , Financial Services Brokers and Dealers Other Assets and Deferred Costs Investments in Federal Home Loan Bank and Federal Reserve Bank Stock that are accounted for in accordance with ASC In addition to the aforementioned exclusions, ASC puts forth a measurement alternative whereby entities can make an election on a security-by-security basis to account for equity securities that do not have readily determinable fair values at cost, with adjustments for impairment and observable price changes in orderly transactions for the identical or a similar investment of the same issuer reflected in earnings. In other words, such securities are adjusted to fair value when an observable price change occurs or impairment is identified. This measurement alternative is not available for securities that qualify for the net asset value practical expedient under ASC , nor can it be elected by the entities noted earlier that are excluded from the scope of ASC The election is to be made on a security-by-security basis and with one exception, any security for which the election is made is required to be accounted for in this manner until it no longer qualifies, which could be the case, for example, if its fair value becomes readily determinable or if the security becomes eligible for the aforementioned net asset value practical expedient. ASU permits an entity that elected to account for a security under the measurement alternative to subsequently change to a fair value method through an irrevocable election that would apply to that security and all identical or similar investments of the same issuer that the entity currently holds or purchases in the future. It should be noted that an equity security is deemed to have a readily determinable fair value if it meets any of the following conditions: Sales prices or bid-and-asked quotations are currently available on a securities exchange registered with the Securities and Exchange Commission or in the over-the-counter market (if publicly reported by the National Association of Securities Dealers Automated Quotations systems or by OTC Markets Group Inc.). Restricted stock meets this definition if the restriction terminates within one year. The security is traded in a foreign market of a breadth and scope comparable to one of the U.S. markets referred to in the previous bullet point. 2

3 The security is an investment in a mutual fund or similar structure, and the fair value per share is determined and published and is the basis for current transactions. Any securities accounted for under this measurement alternative are required to be evaluated for impairment under a one-step impairment model whereby if a qualitative analysis indicates impairment exists, the fair value of the security will need to be estimated and any excess of carrying value over its fair value recognized in net income. Impairment indicators to consider include, but are not limited to, the following: A significant deterioration in the earnings performance, credit rating, asset quality or business prospects of the investee A significant adverse change in the regulatory, economic or technological environment of the investee A significant adverse change in the general market condition of either the geographical area or the industry in which the investee operates A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar investment for an amount less than the carrying amount of that investment Factors that raise significant concerns about the investee s ability to continue as a going concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants The requirement to adjust the carrying amount for observable price changes in orderly transactions for the identical or a similar investment of the same issuer necessitates considering relevant transactions that occurred on or before the balance sheet date that are known or can reasonably be known. An entity is not expected to conduct an exhaustive search, but rather make a reasonable effort to identify observable transactions. ASU does not elaborate on what may constitute a reasonable effort. ASU clarified that if the measurement alternative is elected for a forward contract or purchased option, the entire fair value of the forward contract or purchased option should be remeasured when observable transactions occur on the underlying securities. In evaluating whether a security issued by the same issuer is similar to an equity security held by the reporting entity, consideration should be given to the different rights and obligations of the securities, such as rights related to voting, distributions, liquidation preferences and conversion. If the security is deemed to be similar, any observable prices associated with it should be adjusted for the different rights and obligations in determining the adjusted carrying value of the security held by the reporting entity. ASU clarified that any adjustment made to a security that is accounted for under the measurement alternative as a consequence of an observable price change for a similar investment of the same issuer should be made to reflect the fair value of the security held by the entity as of the date that the observable transaction for a similar security took place. Middle market insights Careful consideration should be given to the advantages and disadvantages of the measurement alternative when a middle market company is deciding whether to elect it for a qualifying security. One significant advantage is that if the exception is elected, it will generally not be necessary to estimate a fair value for the security unless impairment is identified. Another potential advantage is the possibility for this method to result in less earnings volatility as all changes in fair value are recognized in earnings if the exception is not elected for a particular security, while only impairment and observable price changes are recognized in earnings if the exception is elected. Disadvantages include the fact that if impairment is recognized, it cannot be reversed unless an observable price change supports an upward adjustment to the carrying amount. Additionally, there are notable ongoing efforts necessary to apply the measurement alternative. Consider, for example, the need to put in place processes to: (a) reassess individual securities to determine if they continue to qualify for the exception, (b) put forth reasonable effort to identify observable price changes for the security or similar securities of the issuer (which entails an analysis to determine if other securities with observable transactions are similar, and if so, how the observable price should be adjusted for differences between the 3

4 securities), (c) determine if the transactions resulting in observable prices were orderly and (d) assess the security for impairment and if impaired, estimate the fair value. Keep in mind that while these efforts could be significant and require considerable use of judgment, the measurement alternative is designed and expected to be less burdensome than determining a fair value estimate in accordance with ASC 820, Fair Value Measurement, at the end of each reporting period. Valuation allowance for deferred tax assets associated with AFS debt securities To address divergence in practice, the assessment of the need for a valuation allowance for a deferred tax asset related to an AFS debt security should be made in combination with the entity s other deferred tax assets. This constitutes a change for those reporting entities who previously evaluated the need for a valuation allowance discretely for deferred tax assets associated with unrealized losses on these debt securities and concluded the deferred tax asset was realizable based on the intent and ability to hold the securities until maturity. Recognition of changes in fair value of liabilities attributable to instrument-specific credit risk For those liabilities that an entity elects to account for at fair value under ASC , Financial Instruments Overall, or as clarified by ASU , under ASC , Derivatives and Hedging Embedded Derivatives, changes in fair value attributable to instrument-specific credit risk are no longer recorded in net income. Instead, such changes are recorded in OCI to prevent the counterintuitive result of entities reporting gains in net income as their own creditworthiness deteriorates. This change does not apply to derivative or other liabilities for which fair value accounting is a requirement rather than an option, nor does it apply to financial liabilities of a consolidated collateralized financing entity measured using the measurement alternative described beginning at ASC An entity is permitted to assume that the portion of the total change in fair value that exceeds the amount resulting from a change in a base market rate, such as a risk-free or benchmark interest rate (e.g., LIBOR), is the change in instrument-specific credit risk. Alternatively, an entity can quantify the effect of changes in instrument-specific credit risk using another method that it considers to be more faithfully representative. The method chosen should be disclosed and consistently applied. ASU clarified the application of this guidance to a foreign-currency-denominated financial liability for which the fair value option is elected. Namely, the amount of change in fair value that relates to the instrument-specific credit risk should first be measured in the currency of denomination. Then, both components of the change in the fair value of the liability should be remeasured into the functional currency of the reporting entity using end-ofperiod spot rates. At the time that a financial liability designated under the fair value option is derecognized, the cumulative amount of the gain or loss that resulted from changes in instrument-specific credit risk is recognized in net income. Available for early adoption While ASU has a deferred effective date, reporting entities may early adopt this particular provision. Financial instrument disclosure requirements New disclosure requirements contained within ASU are as follows: Disclosure of all financial assets and financial liabilities grouped by both measurement category (e.g., amortized cost, fair value through OCI, fair value through net income) and form of financial asset (e.g., loan, debt security) Disclosure of the carrying amount of equity securities for which the aforementioned measurement alternative is elected, as well as the amount of adjustments made to the carrying amount for observable price changes and impairment during the reporting period the quantitative disclosures should be supplemented with narrative discussing the information that the entity considered in reaching the carrying amounts and adjustments resulting from observable price changes 4

5 Disclosure of the net gains and losses recognized during the period on equity securities less those net gains or losses on securities sold during the period to arrive at the recognized net unrealized gains and losses on equity securities that are held on the reporting date As it relates to liabilities that are accounted for under the fair value option, disclosure of: (a) the change (during the reporting period and cumulatively) in the fair value that is attributable to changes in the instrument-specific credit risk, (b) narrative discussing how the gains and losses attributable to changes in instrument-specific credit risk were determined and (c) if a liability accounted for under the fair value option is settled during the period, any amount recognized in OCI that was recognized in net income at settlement In addition to the above new requirements, existing fair value disclosure requirements were modified. The existing requirement under ASC 825 to disclose the fair value of all financial instruments (including those measured at amortized cost) no longer applies to entities who are not PBEs. Available for early adoption Entities that are not PBEs can early adopt the provision to not disclose the fair value of financial instruments measured at amortized cost in financial statements of fiscal years or interim periods that have not been made available for issuance. With some exceptions, including equity securities accounted for under the measurement alternative, trade receivables and payables due in one year or less, and demand deposit liabilities, PBEs remain subject to the requirement to disclose the fair value of financial instruments measured at amortized cost and will be required to determine the fair value in accordance with the provisions of ASC 820; however, they are no longer required to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments measured at amortized cost. As an alternative to disclosure in the footnotes, the fair value may be presented parenthetically on the face of the statement of financial position. Middle market insights The requirement for PBEs to determine the fair value of financial instruments measured at amortized cost in accordance with ASC 820 could represent a significant change for middle market financial institutions that have been using an entry price approach to estimate the fair value of loans for disclosure purposes based on the example contained within ASC All entities remain subject to the requirement to provide the fair value disclosures contained in ASC 820 for those financial instruments that are measured at fair value in periods subsequent to initial recognition. Lastly, there are additional interim and annual disclosure requirements contained in ASU that are consistent with ASC related to the change in accounting principle. Effective date and transition ASU is effective for PBEs for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. For those entities that are not PBEs, ASU is effective for fiscal years beginning after December 15, 2018, and for interim periods within fiscal years beginning after December 15, Early adoption is permitted for all entities upon issuance of ASU for the provision related to recognizing in OCI the changes in the fair value of an entity s own liabilities attributable to instrument-specific credit risk when the fair value option has been elected. In addition, for entities other than PBEs: (a) early adoption is permitted upon issuance of ASU for the provision related to the elimination of the fair value disclosure requirements for financial instruments reported at amortized cost and (b) early adoption of the new provisions in their totality is permitted upon the effective date for PBEs. For the provisions they are permitted to early adopt, PBEs can only make the election to early adopt in financial statements that have not yet been issued and entities other than PBEs can only make the election to early adopt in financial statements that have not yet been made available for issuance. ASU is effective for PBEs for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years beginning after June 15, In other words, PBEs with fiscal years beginning between December 5

6 15, 2017, and June 15, 2018, are not required to adopt ASU until the interim period beginning after June 15, PBEs with fiscal years beginning between June 15, 2018, and December 15, 2018, are not required to adopt ASU before adopting ASU For all other entities, the effective date for ASU is the same as the effective date in ASU Transition is prospective as it relates to: (a) the measurement alternative for equity securities without readily determinable fair values that exist as of the adoption date and the related disclosure requirements and (b) the requirement for PBEs to determine the fair value of financial instruments measured at amortized cost in accordance with an exit price notion under ASC 820. If, as a result of the prospective application of this latter provision, the prior year amounts are no longer comparable, this fact should be disclosed and explained. Transition for all other aspects of ASU is through a cumulative effect adjustment to the statement of financial position as of the beginning of the first reporting period in which the guidance is applied. (As clarified by ASU , this includes transition for equity securities without a readily determinable fair value for which the measurement alternative is not elected.) Insurance entities that elect the measurement alternative for any equity securities that do not have a readily determinable fair value will face transition nuances associated with any amounts that are recorded in OCI for these securities on the date of adoption. (Due to industry guidance contained in ASC , insurance entities subject to its scope are required to report unrealized gains and losses on equity securities that do not have a readily determinable fair value in OCI.) Given that transition is prospective for equity securities accounted for under the measurement alternative and given that as noted in the Basis for Conclusions of ASU , the guidance does not prescribe a methodology that should be used to prospectively recognize any amounts in OCI, an insurance entity subject to the guidance in Topic 944, Financial Services Insurance, should select a methodology and apply it consistently to all equity securities for which the measurement alternative is elected. Planning for implementation Given that ASU has started coming into effect (beginning in the first quarter of 2018 for calendar year-end public business entities), we encourage all entities to be focused on implementation. In that regard, questions such as the following should be considered: If you elect the fair value option for any liabilities, how will you quantify changes in fair value attributable to instrument-specific credit risk? Would it make sense to elect the measurement alternative for any qualifying equity securities that do not have readily determinable fair values? If so, what processes will you put in place to: (a) reassess individual securities to determine if they continue to qualify for the exception, (b) determine what relevant observable price changes occurred and (c) assess impairment? What will be the impact to key performance measures and the ramifications of the volatility associated with recording changes in the fair value of equity securities through net income? How will you manage the expectations of investors, lenders and other key stakeholders? If you previously evaluated the need for a valuation allowance for deferred tax assets associated with AFS debt securities in isolation, what impact will evaluating it in conjunction with other deferred tax items have? If you are a PBE that determines the fair value of loans using an entrance price for disclosure purposes, how will you estimate fair value based on an exit price in accordance with ASC 820? What changes may otherwise be necessary to systems, processes and controls to comply with the accounting and disclosure changes in ASU ? Convergence On July 24, 2014, the International Accounting Standards Board (IASB) completed its project on financial instruments by issuing amendments to IFRS 9. As amended, IFRS 9 is effective for annual periods beginning on or after January 1, 2018, with early application permitted. Convergence was not achieved, despite the fact that financial instruments began as a joint project of the IASB and the FASB. Divergence may, in fact, be greater than when the joint project began. Some of the more notable differences relate to the following guidance in IFRS 9: An entity can elect to account for certain equity investments at fair value through OCI rather than account for them at fair value through net income. Classification of other financial assets is based on the contractual cash flow characteristics (CCFC) of the instrument and the business model in which the assets are managed. Depending on the facts and 6

7 circumstances, the accounting outcome could be fair value through net income, fair value through OCI or amortized cost for both loans and debt securities. Financial assets are no longer subject to the derivative bifurcation requirements. The fair value option is more restrictive compared to ASC 825 in U.S. GAAP. The following chart provides a comparison of current U.S. GAAP to the requirements of ASU as clarified and IFRS 9. The discussion for specific financial instruments assumes the fair value option has not been elected. For those financial assets subject to credit risk (e.g., debt securities, loans), the discussion of the requirements of ASU is supplemented with a mention of how credit losses will be recognized and measured based on ASU , Financial Instruments Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. For additional information about the new credit losses standard, refer to our in-depth white paper, Financial instruments: In-depth analysis of new standard on credit losses. The IASB impairment model is contained within IFRS 9 and generally requires lifetime expected credit loss recognition for those instruments within its scope for which there have been significant increases in credit risk since initial recognition and 12-month expected credit loss recognition for other instruments within its scope. Financial instrument Equity securities with readily determinable fair values (excluding those accounted for under the equity method) Current U.S. GAAP Classified as trading securities and accounted for at fair value through net income (FV-NI) or classified as AFS securities and accounted for at fair value through OCI (FV-OCI) ASU and ASU FV-NI IFRS 9 FV-NI, unless election is made for FV- OCI for securities not held for trading For AFS equity securities that are determined to be other than temporarily impaired (OTTI), the full amount of impairment is recognized in net income Accounted for under the cost method with recognition of OTTI Equity securities that do not have readily determinable fair values (excluding those accounted for under the equity method) FV-NI except those securities that qualify for the measurement alternative and for which it has been elected, which are accounted for at cost as adjusted through net income for observable price changes and impairment No change to current U.S. GAAP FV-NI, unless election is made for FV- OCI for securities not held for trading Equity investments that give the investor the ability to exercise significant influence Accounted for under the equity method as described in ASC 323 Accounted for under the equity method as described in International Accounting Standard 28, Investments in Associates and Joint Ventures 7

8 Financial instrument Debt security Current U.S. GAAP Classified as trading, AFS or held to maturity (HTM) and accounted for at: FV-NI if trading FV-OCI if AFS Amortized cost if HTM Impairment is recognized on AFS and HTM debt securities if they are OTTI. If the entity intends to sell the security or will more likely than not be required to sell before recovery, full impairment is recognized in net income. Otherwise, credit loss is recognized in net income, and the remainder is recognized in OCI ASU and ASU No change to current U.S. GAAP related to classification and measurement As it relates to impairment, current U.S. GAAP was retained for AFS debt securities with some modification, including that credit losses will be recognized through an allowance, limited to the amount by which the amortized cost of an individual security exceeds its fair value, that will be reversed as cash flow expectations improve. Expected credit losses on HTM debt securities will be recognized through an allowance regardless of whether fair value is below amortized cost IFRS 9 Amortized cost, FV- OCI or FV-NI based on the business model for managing the assets and CCFC Impairment recognized under the IASB expected loss model summarized earlier Loans receivable Amortized cost Lower of cost or fair value if held for sale Impairment is recognized for probable losses through an allowance No change to current U.S. GAAP for classification and measurement Credit losses that are expected to occur over the life of loans carried at amortized cost will be recognized through an allowance Amortized cost, FV- OCI or FV-NI based on the business model for managing the assets and CCFC Impairment recognized under the IASB expected loss model summarized earlier Financial liabilities (generally) Amortized cost No change to current U.S. GAAP Amortized cost 8

9 Financial instrument Fair value option Hybrid financial assets Hybrid financial liabilities Standalone, undesignated derivative assets and liabilities Current U.S. GAAP Can elect for recognized financial assets and liabilities (amongst other items) with certain exclusions, including consolidated entities, demand deposit liabilities and instruments classified in part in equity (e.g., convertible debt for which a beneficial conversion feature was separately recognized in equity) If elected, all changes in fair value are recognized through net income Embedded derivative is bifurcated and recorded at fair value if required under ASC 815, with the host contract following the accounting applicable to the type of host Embedded derivative is bifurcated and recorded at fair value if required under ASC 815 with the host contract following the accounting applicable to the type of host ASU and ASU No change from current U.S. GAAP related to applicability; however, changes in the fair value of liabilities attributable to instrument-specific credit risk should be recorded through OCI instead of earnings No change to current U.S. GAAP No change to current U.S. GAAP IFRS 9 FV-NI FV-NI FV-NI Can elect for financial assets if doing so eliminates or significantly reduces an accounting mismatch Can elect for certain financial liabilities with embedded derivatives. Can also elect for financial liabilities when doing so results in more relevant information because either: (a) it eliminates or significantly reduces an accounting mismatch or (b) a group of financial liabilities or financial assets and financial liabilities is managed and its performance is evaluated on a fair value basis. Changes in fair value attributable to the credit risk of the liability are recognized through OCI unless such treatment would create or increase an accounting mismatch Entire asset is classified at amortized cost, FV-OCI or FV-NI based on the business model for managing the asset and CCFC. No separate recognition of embedded derivatives Similar to U.S. GAAP 9

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