Accounting for financial instruments: Overview of FASB s exposure draft on recognition and measurement Contact: Faye Miller, Director, National Accounting Standards Group, McGladrey LLP faye.miller@mcgladrey.com March 2013 Background On February 14, 2013, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU), Financial Instruments Overall (Subtopic 825-10) Recognition and Measurement of Financial Assets and Financial Liabilities, which proposes a new and comprehensive recognition and measurement model that would replace the instrument-specific guidance currently in U.S. generally accepted accounting principles (GAAP). Financial assets within the scope of the guidance, regardless of legal form, would be classified based on the asset s cash flow characteristics and how an entity manages the assets. Financial liabilities would be accounted for at amortized cost except in limited situations. The proposed ASU resulted from the financial instruments project, which is a joint project of the FASB and the International Accounting Standards Board (IASB) (collectively, the Boards). While it was initiated as a joint project, for the most part each board initially approached the project separately. In May 2010, the FASB issued a comprehensive proposed ASU (the 2010 proposed ASU) on the project as a whole that covered recognition, measurement, impairment and hedging. 1 The 2010 proposed ASU would have required fair value measurement for most financial instruments and, therefore, was highly controversial given the volatility this would introduce to financial statements. In addition, the direction taken by the FASB in its 2010 proposed ASU differed in many significant respects from the direction taken by the IASB in its work on the financial instruments project. As the FASB evaluated the feedback on the 2010 proposed ASU, it engaged in joint redeliberations with the IASB. In the recently issued proposed ASU, the FASB took a different approach to the recognition and measurement of financial assets and financial liabilities compared to the 2010 proposed ASU in that the new approach does not require as many financial instruments to be carried at fair value. As a consequence, the new approach results in a greater degree of convergence with the IASB. The major provisions of the recently issued proposed ASU are summarized in this white paper. 1 The FASB subsequently decided to approach the project in three parts: (1) recognition and measurement, (2) impairment and (3) hedging. Refer to our white paper entitled Credit impairment A long and winding road for more information on a recently issued proposed ASU on credit impairment. The FASB has not redeliberated hedging since the 2010 proposed ASU.
Scope The guidance in the proposed ASU would apply to all entities; however, brokers and dealers in securities, investment companies, agricultural entities and depository and lending institutions would continue to apply certain specialized industry guidance. In addition, the proposed ASU provides specific guidance related to applying certain of its provisions to financial instruments held by not-for-profit entities. While all entities that hold financial assets or owe financial liabilities would be within the scope of the proposed ASU, it is expected that entities such as financial institutions that hold a significant amount of financial assets that are not carried at fair value with changes in fair value recognized in net income would be most affected. In contrast, entities such as investment companies that measure most financial instruments at fair value under current GAAP or nonfinancial entities that generally hold limited amounts of financial instruments would be less affected. Refer to Appendix A for a summary of application considerations of the proposed guidance to entities in certain industries. While the guidance in the proposed ASU would apply to most financial instruments, there is a lengthy list of scope exclusions. Common financial instruments within the scope of the proposed ASU would include investment securities, trade receivables, trade payables, loans, commitments to loan from the lender s perspective, liabilities to depositors of financial institutions and debt. The financial instruments that would be excluded from the scope of the proposed ASU include the following: y Instruments or components of instruments classified as equity y Stock compensation y Benefit plan obligations and the related plan assets y Certain instruments within the scope of the FASB s Accounting Standards Codification (ASC) Topic 944, Financial Services Insurance y A policyholder s investment in a life insurance contract y Equity method investments that are not held for sale y Noncontrolling interests and equity investments in consolidated subsidiaries y Interests in consolidated variable interest entities y Lease receivables and payables y Loan commitments and commercial letters of credit from the borrower s perspective y Conditional obligations under registration payment arrangements y Acquisition-related contracts and contingent consideration associated with a business combination y Not-for-profit entities pledges receivable and payable y Financial guarantee contracts y Certain forward contracts subject to ASC 480, Distinguishing Liabilities from Equity, or related to regular-way securities trades y Derivative instruments within the scope of ASC 815, Derivatives and Hedging, and certain derivative instruments excluded from the scope of ASC 815 Recognition A financial instrument would be recognized on the balance sheet as a financial asset or financial liability (as appropriate) when it is obtained, which would include when the financial asset or financial liability is acquired, originated, incurred, issued or otherwise obtained. 2
Initial measurement Instruments would be initially measured at transaction price if subsequent measurement is either at amortized cost (AC) or at fair value with qualifying changes recognized in other comprehensive income (FV-OCI). Transaction fees and costs, such as net loan origination fees and debt issuance costs, would continue to be accounted for under current GAAP. Instruments that are subsequently measured at fair value with changes in fair value recognized in net income (FV-NI) would also be initially measured at fair value and the transaction fees and costs associated with such instruments would be expensed upfront. If part of the consideration given or received in a transaction involving a financial instrument is for something other than the financial instrument, when allocating the consideration to the various components of the transaction, the financial instrument would be initially measured at fair value in all cases. Subsequent measurement Financial assets The subsequent accounting for financial assets would depend on: (a) whether a contractual cash flows criterion has been met and (b) if so, the business model used to collectively manage those assets. Contractual cash flows criterion The contractual cash flows criterion would be met if a financial asset s contractual terms provide for cash flows on specified dates that consist solely of principal and interest payments on the principal amount outstanding. In making this determination, principal would be defined as the amount transferred by the holder at initial recognition, and interest would be defined as consideration for the time value of money and for the credit risk associated with the principal amount outstanding during a particular period of time, which may include a premium for liquidity risk. Financial assets that do not meet the contractual cash flows criterion would be accounted for at FV-NI. As discussed in the next section of this white paper, financial assets that meet the contractual cash flows criterion would be categorized for subsequent accounting purposes based on the business model used to collectively manage those assets. The proposed ASU provides considerable guidance regarding whether contractual terms that change the timing or amount of payments of principal or interest outstanding would result in a conclusion that cash flows consist solely of payments of principal and interest. Based on that guidance, the following are examples of contractual terms that would provide for cash flows that consist of more than payments of principal and interest: y Variable interest rates that are not just consideration for the time value of money and credit risk y Terms that introduce leverage that modifies the economic relationship between principal and the consideration for the time value of money and credit risk such that the financial assets cash flows are more than insignificantly different from benchmark cash flows y Interest rate reset features for which the frequency of the reset does not match the period of time covered by the interest rate (e.g., interest rate is reset monthly to a three-month rate) such that the financial assets cash flows are more than insignificantly different from benchmark cash flows y Options or terms that extend or accelerate payment unless both of the following conditions are met: 1. The option or term is not contingent on future events, other than to protect: (a) the holder against the credit deterioration of the issuer or a change in control of the issuer or (b) either party against changes in relevant taxation or law 3
2. For options or terms that accelerate payment, prepayment amounts substantially represent unpaid amounts of principal and interest on the principal amount outstanding, which may include reasonable additional compensation for the early termination of the contract For options or terms that extend payment, contractual cash flows during the extension period consist solely of payments of principal and interest on the principal amount outstanding y Conversion options in a debt instrument (because the cash flows are also linked to the value of the issuer s equity instruments) In certain circumstances, when making the determination of whether contractual terms cause an instrument to provide for cash flows that consist of more than principal and interest payments on the principal amount outstanding, it would be appropriate to compare the cash flows of the instrument under evaluation to benchmark cash flows from a comparable financial asset that has the same credit quality and terms except for the term being analyzed. For example, if the financial asset under assessment contains a variable interest rate that is resettable monthly to a three-month interest rate, the benchmark instrument would be an instrument with the same contractual terms and credit quality except that the variable interest rate would be resettable to a monthly interest rate. If the term could result in cash flows that are more than insignificantly different from the benchmark cash flows, the financial asset would not meet the contractual cash flow criterion and, as a result, would be classified as FV-NI. When assessing contractual terms that are contingent, one would not consider the probability of the contingent event occurring when determining whether the contractual cash flows are solely payments of principal and interest in applying the contractual cash flows criterion. However, an entity would disregard the contingent term if it would affect the instrument s contractual cash flows only on the occurrence of an event that is extremely rare, highly abnormal and very unlikely to occur. The proposed ASU provides separate guidance pertaining to beneficial interests in securitized financial assets whereby several conditions would need to be met for an entity to conclude the contractual cash flows criterion has been met. Business model assessment The accounting for financial assets that meet the contractual cash flows criterion would depend on the business model used to collectively manage those assets at the time of recognition: y AC: Those financial assets for which the business model is to hold them to collect contractual cash flows y FV-OCI: Those financial assets for which the business model is both to hold the assets to collect the contractual cash flows and to sell the assets because the entity had not determined at the point in time the assets were recognized whether it would hold or sell individual assets y FV-NI: Those financial assets not covered by the business models that would result in the application of the FV-OCI or AC accounting models It would not be uncommon for an entity to have more than one business model for managing its financial assets (e.g. certain investments or loans may be managed for the collection of contractual cash flows while others are managed to realize fair value changes). As it relates to pools of similar financial assets, the proposed ASU indicates that it may be appropriate to classify percentages of the pool into different classification categories if: (a) the entity expects to sell a portion of a pool and to continue to hold and manage the other portion to collect the contractual cash flows and (b) the entity had not yet identified at recognition the specific assets that will be subsequently sold. 4
The proposed ASU notes that all objective evidence that is relevant to assessing the entity s business model would be considered, including the following: y How the performance of the business is reported to the entity s key management personnel y How management is compensated (e.g., based on the fair value of the assets managed) y Frequency and volume of sales in prior periods, reasons for sales in the past and expectations about sales activity in the future In determining the appropriate business model classification for a group of collectively managed assets, the FASB indicated in the proposed ASU s implementation guidance that sales of financial assets as a result of a significant deterioration in the issuer s creditworthiness would not be inconsistent with the objective of AC classification if the purpose of those sales is to maximize the collection of contractual cash flows through sales rather than through cash collection. However, sales of financial assets that result from managing the credit exposure because of concentrations of credit risk would not be consistent with the objective of AC classification. The proposed ASU indicates that sales that result from reasons other than managing credit exposure should be very infrequent in the context of financial assets classified as AC. For that reason, the proposed ASU specifically provides the following events or circumstances as examples of reasons for sales that would not be inconsistent with the objective of AC classification, generally because the events would occur very infrequently: y A change in tax law that eliminates or reduces the tax-exempt status of interest on debt instruments y A major business combination or major disposition that results in an entity s reassessment of its business model and subsequent realignment of the assets managed within that business model y A change in statutory or regulatory requirements that significantly modifies either what constitutes a permissible investment or the maximum level of investments in certain kinds of debt instruments y A significant increase by a regulator in the industry s capital requirements that causes the entity to sell financial assets to meet regulatory requirements y A significant increase in the risk weights of debt instruments used for regulatory risk-based capital purposes y An isolated, nonrecurring event or circumstance that is unusual for the entity and that could not have been reasonably anticipated In addition, sales that occur close to maturity with proceeds that approximate the collection of the remaining contractual cash flows would not be inconsistent with the objective of AC classification. While the FASB acknowledged in the proposed ASU s basis for conclusions that sales of financial assets classified as AC for reasons other than those discussed earlier should call into question the entity s credibility for asserting that it holds financial assets for the primary objective of collecting contractual cash flows, the proposed ASU does not contain a tainting provision like the one in current GAAP. The FASB decided to address this issue by expressing objectives and implementation guidance rather than by establishing strict rules. A business activity that entails managing exposure to interest rate risk, maintaining a certain yield profile or managing liquidity by holding and selling financial assets would be consistent with the primary objective for FV-OCI classification. Reclassifications between AC, FV-OCI and FV-NI would occur under the proposed ASU only when the business model changes (which should be very infrequent) and when certain stringent conditions are met, including that the change must be significant to the entity s operations and must be demonstrable to external parties. 5
The following are examples that would not constitute a change in an entity s business model: y A change in intention related to particular financial assets (even in circumstances of significant changes in market conditions) 2 y The temporary disappearance of a particular market for financial assets y A transfer of financial assets between parts of the entity with different business models The reclassification would be prospective and its financial statement effects would depend on the nature of the change. If a financial asset appropriately classified as AC is subsequently identified for sale and the net carrying amount of the financial asset is more than its fair value, an impairment charge would be recognized in net income for that difference. If, on the other hand, the net carrying amount of the financial asset is less than its fair value, a gain would not be recognized until the financial asset is sold. While the financial asset would continue to be classified as AC, it would be presented in a separate category on the balance sheet. Subsequent measurement Equity securities Because investments in equity securities would not meet the contractual cash flows criterion, those within the scope of the proposed ASU would be accounted for at FV-NI. If elected, a practicability exception would allow entities (other than brokers and dealers and investment companies) to measure an equity investment without a readily determinable fair value at its cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical investment or a similar investment of the same issuer. The practicability exception might not be available in situations involving entities that calculate net asset value per share (or its equivalent). The eligibility of each investment for this exception would have to be reassessed every reporting period. Equity securities for which the practicability exception was elected would be evaluated for impairment by giving consideration to certain qualitative impairment indicators. If the investment is deemed to be impaired, an entity would need to estimate the fair value of the investment and record an impairment loss to the extent the carrying value of the security exceeds the fair value. This impairment model would also be applied to investments in equity securities accounted for under the equity method, which, as indicated earlier in this white paper, are otherwise excluded from the scope of the proposed ASU. Subsequent measurement Financial liabilities Financial liabilities within the scope of the proposed ASU would be accounted for at AC unless: (a) the liability results from a short sale or the business strategy upon incurring the liability is to subsequently transact at fair value, in which case the financial liability would be accounted for at FV-NI or (b) the contractual terms of a nonrecourse financial liability require the entity to settle the entire liability with only the cash flows from the related financial assets, in which case the accounting model used would be based on the accounting model applied to the related financial assets. Loan commitments, revolving lines of credit and commercial letters of credit The issuer s (i.e., potential lender s) accounting for a loan commitment (or revolving line of credit or commercial letter of credit) would depend on the likelihood of the counterparty exercising the commitment. 2 Unlike current GAAP, the classification would not be based on management s intentions for specific assets, but rather the business model through which the group of assets are collectively managed. 6
If the likelihood of the counterparty exercising a commitment is not remote when it is entered into, the issuer would classify the loan commitment based on the classification of the underlying loan that would be made if the commitment is exercised. As such, if the underlying loan would be measured at FV-NI, the commitment would also be measured at FV-NI. If the underlying loan would be measured at AC, any commitment fee received would be recognized over the life of the funded loan. If the likelihood of the counterparty exercising a commitment is remote, the issuer would recognize any commitment fee it received over the commitment period in accordance with current GAAP. Hybrid instruments A hybrid financial asset would be classified in its entirety using the same approach discussed earlier for financial assets and not separated between its derivative and nonderivative components. Current GAAP would be applied to a hybrid financial liability to determine whether it should be separated into its derivative and nonderivative components. The guidance in the proposed ASU for measuring a financial liability would then be applied to the financial liability host contract or the hybrid financial liability in its entirety (as appropriate) unless specialized guidance applies. Hybrid nonfinancial assets would be accounted for in their entirety at FV-NI if certain conditions are met. The accounting for hybrid nonfinancial liabilities would depend on a number of factors, including the results of applying the guidance in current GAAP related to the bifurcation of embedded derivatives. Fair value option Use of the fair value option under the proposed ASU would be limited to: (a) certain hybrid financial liabilities, (b) groups of financial assets and liabilities for which the entity manages the net exposure on a fair value basis and provides information on a net exposure basis to its management, (c) financial assets otherwise eligible to be classified as FV-OCI and (d) hybrid nonfinancial liabilities under certain circumstances. Changes in the fair value of financial liabilities for which the fair value option has been elected that are attributable to instrumentspecific credit risk would be recognized in other comprehensive income instead of net income. For purposes of estimating the portion of the total change in fair value attributable to instrument-specific credit risk, the entity could use the amount by which the total change in fair value exceeds the amount resulting from a change in a base market risk, such as a risk-free interest rate. Alternatively, an entity could use another method that more faithfully represents the portion of the total change in fair value resulting from a change in instrument-specific credit risk. The method used would need to be consistently applied and disclosed. Deferred tax assets The proposed ASU would require an entity to evaluate the need for a valuation allowance on a deferred tax asset related to unrealized losses on instruments classified at FV-OCI separately from the entity s other deferred tax assets. Presentation and disclosure The proposed ASU includes various new financial statement presentation and disclosure requirements. From a presentation perspective, an entity would show financial assets and financial liabilities on the balance sheet according to how they are classified (e.g., FV-NI, FV-OCI, AC). Additionally, certain income statement activity would be segregated in the same manner. Public entities would be required to present the fair value of financial instruments (other than receivables and payables due in less than one year and demand deposit 7
liabilities) measured at AC parenthetically on the face of the balance sheet. As indicated earlier in the white paper, financial assets that are initially carried at AC but subsequently identified for sale would be presented as a separate line item on the balance sheet. These are just a sample of the new presentation requirements in the proposed ASU. New disclosure requirements would result in entities providing the following in the notes to their financial statements: y Information about reclassifications due to a change in business model y Information related to sales of financial assets classified as AC or FV-OCI y Information about those securities without readily determinable fair values for which the practicability exception was elected, including: -- The carrying amount of the securities -- The amount of impairments and upward and downward adjustments, if any, both annual and cumulative -- A narrative discussion to permit financial statement users to understand the quantitative disclosures and the information that the entity considered in reaching the carrying amounts and upward or downward adjustments resulting from observable price changes y For public entities, information about core deposit liabilities, including disaggregated balances, implied weighted average maturities and estimated all-in-cost-to-service rates These are just a sample of the new disclosure requirements in the proposed ASU. Transition and effective date The transition provisions in the proposed ASU would require a cumulative-effect adjustment to the balance sheet at the beginning of the first reporting period in which the guidance is effective. Numerous transitionrelated disclosures would be required. An effective date is not included in the proposed ASU as the FASB has deferred making any decision with respect to the effective date until they are in the final stages of their redeliberations. However, the FASB has decided that early adoption would not be permitted, with one limited exception related to the presentation of changes in instrument-specific credit risk for hybrid financial liabilities measured at FV-NI. Comment period deadline Comments are due on the proposed ASU by May 15, 2013. Convergence With respect to where the FASB stands related to converging with the IASB on the recognition and measurement of financial instruments, the Boards have reached near agreement related to the accounting for investments in debt instruments when one considers the amendments the IASB proposed in November 2012 to International Financial Reporting Standards (IFRS) 9, Financial Instruments. Regarding equity investments, a significant difference exists because the IASB permits changes in fair value to be recognized in other comprehensive income rather than net income if the securities are not held for trading. Additionally, there are differences in the circumstances under which an election can be made to account for financial instruments at FV-NI. 8
Appendix A: Application considerations of the proposed guidance to entities in certain industries Industry Depository and lending institutions Insurance entities Brokers and dealers Investment companies Not-for-profit entities Agricultural entities Employee benefit plans Application considerations of proposed guidance y Existing guidance pertaining to subsequent measurement of Federal Home Loan Bank and Federal Reserve Bank stock would be retained; however, the impairment guidance for equity securities not measured at FV-NI would be relevant y Existing guidance pertaining to subsequent measurement of National Credit Union Share Insurance Fund deposits would be retained y Instruments within the scope of ASC 944 would be excluded from the scope of the proposed ASU except mortgage loans, investments and debt y Financial liabilities would be subject to the scope, but otherwise, the existing guidance in ASC 940, Financial Services Broker and Dealers, would be retained y Investments in exchange memberships would be tested for impairment using the impairment guidance for equity securities not measured at FV-NI y Would not be able to elect the practicability exception that would allow carrying equity securities without readily determinable fair values at cost (as adjusted for certain items) y The existing guidance in ASC 946, Financial Services Investment Companies, would be retained, but all other assets and liabilities not addressed in ASC 946 would be within the scope y Presentation and disclosure requirements would be applicable y Financial assets subject to the scope could not be classified at FV-OCI y Would not be able to elect the practicability exception that would allow carrying equity securities without readily determinable fair values at cost (as adjusted for certain items) y Contribution receivables and payables would be excluded from the scope y Portfolio-wide fair value option for other investments would be retained y Instruments otherwise eligible for classification as FV-OCI would be initially measured at transaction price y Entities that do not report a performance indicator under ASC 954, Health Care Entities, would report changes in fair value as a change in the appropriate net asset class in a statement of activities y Entities that report a performance indicator would report changes that would: (a) otherwise be reported in net income within the performance indicator and (b) otherwise be reported in OCI outside the performance indicator y Certain existing guidance applicable to investments in agricultural cooperatives would be retained y Plan obligations and related plan assets of defined benefit pension plans, defined contribution pension plans and health and welfare benefit plans would be excluded from the scope 9
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