New rules on how to classify and measure financial instruments take effect next year, but companies may not be paying nearly as much attention to it as they are to approaching revenue recognition and lease accounting standards.
All public companies are required to adopt a new standard on the classification and measurement of financial instruments in 2018. Yes, that’s the same launch date as a much bigger standard on recognizing revenue in financial statements, to be followed a year later by a new method to account for leases.
Public companies have had the new rules for revenue recognition in their hands since May 2014, although efforts to understand the new revenue rules and prepare for implementation led to a handful of clarifications that followed. The new rules on financial instruments emerged from the Financial Accounting Standards Board in 2016.
While both standards take effect in 2018, the more pervasive revenue rules have won the lion’s share of attention over the past several months. “It [financial instruments] hasn’t been getting a lot of press, and the effective date will be here before we know it,” says Faye Miller, a parter at audit firm RSM. “We’re trying to make sure it isn’t getting lost in the sea of pending new guidance.”
Even the new leasing rules, which take effect a year later, have taken some precedence over financial instruments. And for financial institutions, huge new requirements taking effect in 2020 on how to recognize credit impairments also have overshadowed the new financial instrument requirements. “That has taken a lot of oxygen out of the room because it has such wide, sweeping implications on the balance sheet and the income statement,” says Rick Childs, a partner at Crowe Horwath.
For some companies, letting the new rules on financial instruments fall to the bottom of the pile may be no big deal. For others, that could be a huge problem.
“It [financial instruments] hasn’t been getting a lot of press, and the effective date will be here before we know it. We’re trying to make sure it isn’t getting lost in the sea of pending new guidance.”
Faye Miller, Partner, RSM
The new rules on financial instruments contain a few primary changes that will have varying effects on different types of companies. The first big change is a requirement to measure equity securities that are classified as “available for sale” at fair value rather than historical cost. That means more valuation work, especially for securities that may not be publicly traded, so are more difficult to value.
Under the new standard, changes in those values must be recorded through earnings rather than equity, which always causes a CFO’s heart to skip a beat or two. “It could cause a lot of earnings volatility,” explains Miller. “Companies will have to think about how that is going to impact key performance measures, making sure they’re managing the expectations of investors, lenders, and other key stakeholders,” she says.
The rules provide most companies with a little relief if they’d like to avoid that whole unpleasant scenario, but there’s a tradeoff to be considered there as well. The standard makes some allowances for many companies (those that are not in the investment business, for the most part) to use a simpler formula, eliminating the valuation exercises and earnings volatility. But that doesn’t relieve the company of the obligation to test for impairment and mark securities down when necessary—and those markdowns carry little hope of ever getting marked back up.
That introduces another complexity, says Miller. “If you elect the measurement alternative, you have to have a process in place to continue to monitor those securities,” she says.
Travis Harms, senior vice president at Mercer Capital who leads the firm’s financial reporting valuation group, says operating companies have increased their hold of equity investments in recent years, with corporate-backed venture capital rising to more than 1,200 deals in 2015 valued at more than $30 billion.
Key provisions of ASU 2016-01 on the recognition and measurement of financial instruments:
1. Requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. However, a reporting organization may choose to measure equity investments that do not have readily determinable fair values at cost minus impairment (if any), plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer.
2. Simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When a qualitative assessment indicates that impairment exists, the reporting organization is required to measure the investment at fair value.
3. Eliminates the requirement to disclose the fair value of financial instruments measured at amortized cost for reporting organizations that are not public business entities.
4. Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost on the balance sheet.
5. Requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes.
6. Requires the reporting organization to present separately in other comprehensive income (OCI) the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments.
7. Requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements.
8. Clarifies that the reporting organization should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale securities in combination with the organization’s other deferred tax assets.
“It will be interesting to see how literally the standard is applied—if things can skate by on materiality or lack thereof, or whether these companies will be reporting these investments at their fair value,” Harms says.
Another key change in the standard is focused on how companies will recognize the value of their own debt. While changes in financial instrument liability values historically have gone through earnings—creating inexplicable gains when an entity’s own creditworthiness is declining—now those changes will go through other comprehensive income, which is a component of equity on the balance sheet.
Banks have been doing this already for some time, says Rahul Gupta, a partner at Grant Thornton, and calling it out as a non-GAAP adjustment to make things clearer to investors. “From the user perspective, there’s going to be a new way of seeing the income statement and other comprehensive income when this standard is adopted,” he says.
The rules are likely to be more important at financial services entities, which are more likely to have the kinds of securities in their portfolios that now must be measured differently, but operating companies are not immune. The standard is not technically complicated for companies to apply, but they’re so buried in other accounting change that’s more pervasive, it’s getting less attention.
“We’ve had discussions with middle-market companies that are very focused on this, and then there’s the population where concern exists that this could get lost in the shuffle,” says Miller. “It’s all relative.”
At financial services entities, it’s getting less attention because the current-expected credit loss model under the credit impairment standard is so much more significant, says Childs. The financial instrument standard focuses on individual instruments that must be measured at a point in time. “From a data standpoint, it’s a reasonably straightforward data gathering process,” he says.
CECL, by comparison, is focused on life-of-loan calculations, in some cases spanning multiple decades, for different types of instruments and loan products, says Childs. On top of that, historical data is muddied by results from the financial crisis that do not represent normal market conditions. “That is such a significant undertaking,” he says.
Childs envisions companies running, in effect, risk calculations with respect to the mountain of accounting change they must surmount in the next few years. “How much time do I spend on this compared with CECL and other things, like bank M&A?” he says.
In the case of financial instruments, “it hasn’t risen to the top of the pile,” says Childs. “They know they’ve got to implement it, but a lot are hoping systems will come in later on and deal with it that way,” he says. “They’re also willing to have a little bit of a learning curve, but not on CECL. They’re looking at the questions from analysts, and this isn’t the topic analysts ask about. That’s CECL.”
Harms sees the financial instrument change in the same light as many other accounting changes companies have had to adopt. “There are the stages of grief—shock, indignation, and then figuring out what we actually have to do,” he says. “I’m confident companies will figure out how to navigate that, but there may well be some internal controls and processes that need to be developed to do that efficiently.”