A new accounting standard on how to recognize and measure financial instruments provides a handful of key provisions that will have widely different effects for public companies.
“Clearly the new standard is going to make some changes,” says John Althoff, a partner with PwC. “But the extent of change and whether it impacts you or not will depend on the nature of your business and the nature of the financial assets and financial liabilities you have. It’s hard to give that all-encompassing summary that the world is changing or nothing has happened. It changes some things but not others.”
The biggest changes with Accounting Standards Update No. 2016-01, experts say, involve how to account for investments in equity securities, how to treat credit risk for certain liabilities recognized at fair value, and how to arrive at certain disclosures. The final standard represents a significant step back from the board’s original idea in 2010 to require all instruments to be reported at fair value, or even the compromise proposal in 2013 to focus measurement on the business purpose for holding a particular instrument.
With the rule now final, financial institutions are perhaps most tuned in to changes around debt they have elected to mark at fair value, says Mike Gullette, vice president at the American Bankers Association. Changes in those values will be reflected in “other comprehensive income” rather than net income under the new standard, removing a long-criticized allowance in GAAP that enabled banks with deteriorating credit to improve their reported earnings.
The Financial Accounting Standards Board set a 2018 effective date for the new standard, but it made an exception for the credit risk provision, allowing that to be adopted early. “Banks will probably try to do that quickly,” says Gullette. It’s a common topic of discussion in earnings calls, he says, where banks routinely exclude the impact of the fair-value adjustment in explaining results to investors.
Aside from financial institutions, for public companies across all sectors experts say the most significant change is the requirement in the new standard to measure equity securities at fair value if they are held as available for sale or if their fair values are not readily determinable. Changes in the value of such securities will be reflected in net income under the new standard.
“Clearly the new standard is going to make some changes, but the extent of change and whether it impacts you or not will depend on the nature of your business and the nature of the financial assets and financial liabilities you have.”
John Althoff, Partner, PwC
“If you have investments in loans or debt securities, this standard is not changing that accounting,” says Althoff. “If you have equity instruments you are holding in a trading account, that hasn’t changed. But if you have a lot of equity investments that you are holding as available for sale, or if they do not have readily determinable fair values, this will be a big change for you.”
Under existing GAAP, changes in the value of equity securities that are held for sale are reflected in other comprehensive income, a line item in the income statement that does not flow directly to earnings, says Faye Miller, a partner with audit firm RSM. “Companies will want to give some thought to what this is going to mean when they start experiencing income statement volatility by having to run changes in fair value through the income statement,” she says.
The standard provides an alternative treatment if companies want to elect it, says Miller. Where equity investments do not have readily determinable fair values—for example where a company holds an investment in another private entity—companies can elect to measure those investments at cost minus impairment, plus or minus any changes resulting in more observable evidence. “Once you make that decision, you live with that for the life of each security for which you make that election,” she says.
Below, FASB offers a summary of the new financial instrument standard.
The new ASU:
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.
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.
Eliminates the requirement to disclose the fair value of financial instruments measured at amortized cost for reporting organizations that are not public business entities.
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.
Requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes.
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.
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.
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.
Making the election, however, would necessitate controls and procedures to identify indicators of impairment and observable changes that would have to be reflected, says Miller. “It’s just a question of weighing the benefits and the costs,” she says. “Either way, you will have some ongoing challenges.”
While FASB is working on a separate standard on how to reflect credit impairment, companies should not overlook provisions in the new classification and measurement standard on impairment of equity securities, says Gautam Goswami, a partner with audit firm BDO USA. “This standard gets rid of other-than-temporary impairment” for equity securities, he says. Where companies have elected the alternative treatment to full fair-value measurement each period, the standard requires a qualitative assessment each reporting period to look for indicators of impairment, he says, with any difference between fair value and carrying value reflected.
With respect to disclosures, the new standard requires public companies to use an exit price rather than entry price when measuring the fair value of instruments for disclosure purposes. Although fair value by definition relies on exit pricing, companies have followed an interpretation that for certain disclosures an entry price approach was acceptable, says Mo Vakili, a partner with Deloitte. “FASB is clarifying here if you don’t carry it at fair value but you disclose it at fair value, it should be at an exit price,” she says.
The new standard also reduces some disclosures. Where public companies measure the value of financial instruments at amortized cost on the balance sheet, the new standard will not require disclosure of the methods and significant assumptions used to estimate the fair value that must be disclosed. “It reduces the onus on disclosures,” says Vakili.
Adoption efforts will vary for entities, depending on what’s in their portfolio and how it’s carried currently, says Miller. Compared with other major standards that are already published or expected soon, like revenue recognition, leasing, and credit impairment, the new requirements for classification and measurement of financial instruments will be easier to implement, she says.
In many cases, entities already have information they will need to comply with the new requirements, but they will change how it is reflected in financial statements, says Miller. It is perhaps the exit price notion required in footnote disclosures that may produce some of the greatest leg work for companies, she says. “For entities that have long-term receivable portfolios, if prior to this they were using an entry price notion to determine fair value, it could be a fair amount of effort to convert to obtaining exit pricing,” she says.
As for financial statement metrics, banking experts are not expecting monumental change. “There should be very little change in the balance sheet,” says Gullette. “In the income statement, a small number of companies will be having a difference in what’s reported.”
Miller says it’s hard to project what will happen to income statements across all entities, given that some changes will add what flows to earnings and others will take earnings away. “I’m sure there will be some entities impacted by both, but I don’t have a good feel for how extensive it will be,” she says.