Financial Instruments –
Where are we?
Recognition and Measurement
Impairment
Derivatives
Financial Instruments – Needs Fixing?
•FASB issued a new standard on recognition and measurement that makes “targeted improvements” rather than major changes (ASU 2016 – 01)
•FASB is almost done with its new standard on credit losses which will introduce a new model
•FASB will also be issuing a new proposal for derivatives and hedging to simplify and improve
Classification and Measurement
• FASB dropped their plans previously proposed to make major changes (e.g., more fair value)
(Those ideas got little support)
• The targeted amendments for modest improvements for financial instruments relate to:
Measurement of equity investments
Presentation of changes in fair value of company’s own debt under the fair value option
First, What’s not Changing!
• Classification of debt securities – Although major changes were
proposed, the current framework was retained and it is still OK to use the three buckets:
Trading – carry at fair value with changes through net income
Available for sale – carry at fair value with changes through other comprehensive income (but consider need for impairment).
(Note – an amendment has been made regarding recording deferred taxes)
The “Improvements” – Equity Investments
Today – available for sale category -carry at FV with changes in value through OCI (unless impaired) – GONE!
New Approach – Equity securities carried at FV BUT changes in value will be recorded directly in income (There is also a
measurement alternative for calculating FV).
This does not apply to equity securities that are accounted for under the equity method or are consolidated but it does apply to
Measurement Alternative – An Election!
For equity securities without a readily determinable fair value, investors may elect to measure the securities at cost, less impairment, plus or minus observable price changes (in orderly transactions) of an identical or
similar investment of the same issuer.
Impairment (when using the exception) – No longer will it be necessary to
assess whether the impairment is “other than temporary.” Instead, review a list of qualitative indicators (e.g., investee is incurring losses) and reach a subjective conclusion on whether the investment is impaired. If it is,
FV Option – Company’s Own Debt
Today – if the fair value option is elected, all changes in value are recorded in income.
Odd Result – if company’s own credit rating goes way down (bad), the FV of its debt goes down, and this gives rise to income! Hard to explain!
New Approach – the company’s debt will still be recorded at fair value
under the option BUT the portion of the change in value due to changes in the company’s own credit risk will be recorded in other comprehensive
income (an improvement!).
Disclosures
Relief is being given to non public entities. They are no longer required to make fair value disclosures of investments carried at amortized cost.
Public companies will be able to disclose less fair value information for investments carried at amortized cost (e.g., information on methods
and assumptions used in determining fair value will not be required).
What About Convergence?
FASB and IASB could not quite agree so the IASB issued their own financial instrument standard (IFRS 9, amended).
For example, in IFRS 9, debt securities can be carried at cost only if the instrument simply calls for principal and interest payments.
More complex financial instruments (e.g., embedded derivatives) carry at fair value through income.
Effective Date and Transition for Classification
and Measurement
Public companies – calendar Y/E’s (and interim periods) beginning 1/1/18
Non-public companies – calendar Y/E’s beginning 1/1/19 and interim periods
beginning 1/1/20
Early adoption permitted but only for fair value option and the reduced disclosures for non-public companies.
How to Recognize Impairment
• Problem for loans and securities – too little, too late. A big change should be final soon!
• The new idea (from both FASB and IASB) – The
incurred loss “probable” approach (FASB 5 – 1975) will be gone!
• The new FASB approach will apply to all financial assets (not just held by financial institutions) that are measured at amortized cost.
• It is applicable to financial assets such as loans and commitments, debt securities (held to maturity), trade receivables, lease
receivables.
• Impact for amortized cost financial assets - recognize the current estimate of all expected credit losses sooner!
Expected Losses
• Incurred loss model – gone!
• The allowance for credit losses is a valuation account that is
deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected.
FASB Guidance
• Entities may leverage their existing processes, but may need to modify inputs to reflect expected credit losses rather than asset’s reported amount. • Use not only historical experience and assessment of current conditions but
also reasonable and supportable forecasts that affect the expected
collectability of the asset’s remaining contractual cash flows.
• There is additional guidance on what to do for the period after this “reasonable and supportable” period ends – i.e., revert to unadjusted historical credit loss experience for such future periods.
Other Changes
Available for sale debt securities carried at fair value through OCI – use a
modified version of the current other than temporary impairment model (not the CECL model) except:
Use allowance approach instead of write off that could be reversed
Don’t consider subsequent events or length of time fair value has been under cost
New guidance on purchased financial assets with credit deterioration – referred to as PCD’s
Modified Disclosures
Credit quality disclosures consistent with existing GAAP
Policies for estimating expected credit losses
Period-to-period roll forward of allowance
“Vintage” year disclosures
Effective Date and Transition
• Effective date – 1/1/2019 for SEC filers, later for otherentities. (Note – Just revised to 1/1/2020 allowing early adoption on 1/1/2019).
• Transition – Generally by a cumulative effect adjustment as of the beginning of the year adopted but some requirements for prospective transition (such as PCD assets and AFS
securities previously impaired).
• Disclosures will be required of the impact.
Implementation Issues
• Obtaining historical credit loss data
• Developing reasonable supportable forecasts about the future (community banks have particular concerns)
• Adjusting historical data to reflect forecasted information • New disclosures – operational?
PREPARATION SUGGESTIONS?
IASB’s Three Buckets Model
– A Taste!
Bucket #1 – Loans without significant deterioration, initially record only losses expected to occur in next year. If credit quality
significantly deteriorates move down to Bucket #2 or #3.
For Bucket #2 (groups) or #3 (individual), now record losses expected over the entire life of the loan, not just one year.
This has already been issued in 2014 (in IFRS 9). Europe is not applying it yet.
FASB concluded this bucket approach would retain thresholds for
Derivatives and Hedging – Financial and
Nonfinancial Items (Codification 815)
The New Proposal - will be issued very soon?
Goal – “targeted improvements” to the hedging model (simplification?) –
FASB has been trying for many years now and hedge accounting has been the source of many practice issues - perhaps FASB will finally improve the model and actually make it easier to apply for preparers and more understandable for users.
A taste of proposed improvements
Various changes are being proposed. These include 5 categories:
1. Overall hedge accounting model - Initial quantitative testing required unless certain can use shortcut or critical terms match qualitative methods can be used to assert perfect effectiveness. Subsequent effectiveness testing only necessary if facts and circumstances change. More
flexibility in timing of initial quantitative test (when needed) documentation needs. Changes for
hedging components of nonfinancial risk (commodity risk).
2. Changes in FV of derivatives designated as hedges – No longer will have to split between effective and ineffective portions. Guidance on where to display FV changes. (Also see 5 below.)
3. Hedging benchmark interest rate risk – For variable rate financial instruments (cash flow hedges), can designate the contractual variable interest rate as the hedged risk, no longer
More hedging proposals
4. Fair value hedges of interest rate risk – To determine changes in FV of the
hedged item, use either benchmark component of cash flows or total coupon cash flows. Partial term hedging revised to allow principal repayment at the end of hedge period. Would be able to hedge just a portion of the term of the financial instrument as the hedged risk.
5. Cash flow and net investment hedges – Qualifying investment hedges the entire change in FV of the hedging instrument included in the assessment would be
recorded in OCI (for cash flow hedges) or as part of the cumulative translation adjustment (for net investment hedges).
Summary Views
• Will these financial instruments projects ever end? • How should companies start to get ready?
• Will FASB have to provide more implementation guidance?
• Is there hope for further convergence?
