FASB’s Exposure Draft on Fair Value Would Impact Financial Institutions
One of FASB’s recent efforts to create compatible standards of accounting with IASB would mean most financial instruments would be measured at fair value on the balance sheet each period.
FASB’s Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities (Topics 825 and 815), would significantly impact how debt and equity securities, nonmarketable equity investments, loans, loan commitments, deposit liabilities, trade payables, trade receivables, derivative financial instruments, and debt liabilities are recorded.
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These amendments will require major changes in software and accounting processes.
—David Legge
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“While this is only an exposure draft and we cannot predict the final treatments, we feel our financial institution clients would want to know early on, as these amendments will require major changes in software and accounting processes,” says David Legge, financial institutions principal with LarsonAllen.
The wide-ranging reaction to the exposure draft has caused FASB to extend the comment period to September 30, 2010. The AICPA has already expressed concerns in its official comments to the board.
Fair value classifications
The exposure draft does away with the following current methods of measuring financial instruments: held-to-maturity, available-for-sale, and trading categories. FASB proposes the following new classification criteria:
Abbreviations Key
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FASB: Financial Accounting Standards Board
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IASB: International Accounting Standards Board
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AICPA: American Institute of Certified Public Accountants
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Exposure draft: A proposed standard
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FV-NI: Fair Value-Net Income
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FV-OCI: Fair Value-Other Comprehensive Income
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FV-NI: changes in fair value recognized in net income
This means the instrument is initially measured at fair value and the difference between the fair value and transaction price is recognized in net income. Transactions costs and fees are recognized in net income as incurred.
FV-OCI: changes in fair value recognized in other comprehensive income
These fair value changes will occur initially at the transaction price. The difference between the transaction price and fair value is recognized in other comprehensive income unless there is a “significant” difference between these values. Transactions costs and fees are deferred and recognized in earnings as a yield adjustment over the life of the instrument. In order to apply this classification to a financial asset or liability, several characteristics must be met. (Those details are on pages 35-36 of the exposure draft).
Amortized cost
When using this method, instruments are initially measured at cost. Subsequent transaction costs and fees are deferred and recognized in earnings as a yield adjustment over the life of the instrument.
Demand deposit liabilities
There are many detailed changes in the area of demand deposit liabilities. Currently, demand deposit liabilities are measured at face value. Under the exposure draft, financial institutions must measure demand deposit liabilities at the present value of the average core deposit amount using the implied maturity of deposits. This must be performed for each major type of deposit. The discount rate would be equal to the difference between the alternative funds rate and the all-in-cost services rate, which are described in detail in the exposure draft. When changes are measured in the demand deposit liabilities, these changes are generally recognized in net income unless the criteria for FV-OCI are met. Noncore demand deposits must be measured at fair value. Noncore demand deposits, however, may be recorded at approximate fair value if the maturity is short.
Financial statement presentation
The proposed changes will also impact how information is presented on financial statements.
- Financial statements FV-NI and FV-OCI will be classified separately on the face of the balance sheet.
- Financial assets and liabilities being recorded using FV-OCI will require separate line items for amortized cost, the allowance for credit losses on financial assets, and the accumulated amount needed to reconcile the amortized cost (less allowance for credit losses to fair value).
- Core demand deposit liabilities will disclose the amount due, the amount needed to adjust that amount under the re-measurement method, and the re-measured amount of the deposit.
This guidance also reintroduces the statement of comprehensive income. Going forward, this statement will be required along with the balance sheet, income statement, and statement of changes in stockholders’ equity.
If using FV-NI, one aggregate amount would be presented for realized and unrealized gains and losses. If using FV-OCI, the following three instruments will need to be disclosed separately:
- Interest income and expense (including amortization of any premium or discount at inception)
- Credit impairment for the period
- Realized gain or loss
If using amortized cost, interest expense and realized gain or loss on the settlement of liabilities would need to be disclosed.
Assessment for credit impairments
Unlike the existing guidance, the proposed guidance requires entities to use an allowance account to record credit losses for investments classified as FV-OCI, not just loans. The proposed guidance also requires entities to evaluate investments and loans for impairment on a pool or portfolio basis.
Interest income recognition
The exposure draft instructs entities on how to calculate interest income by applying the effective interest rate on financial assets that are classified as FV-OCI. The effective interest rate would be multiplied by the financial asset less any credit allowance, which would make the current practice of placing loans on nonaccrual status no longer applicable unless the loan has a negative yield. The determination of the effective interest rate depends on whether the financial asset was purchased at a discount related to credit quality.
Tiered implementation schedule
The proposed guidance would be implemented in tiers, starting with public entities. Nonpublic entities with total assets of less than $1 billion will have an additional four years to implement the new requirements relating to loans, loan commitments, and core deposit liabilities that meet certain criteria. Some specific types of financial instruments, such as pension obligations and leases, would be exempt from the proposed guidance, while short-term receivables and payables would continue to be measured at amortized cost.
No proposed effective date
FASB has not yet proposed an effective date, but it is anticipated the board will establish the effective date when it issues the final amendments.
Background
U.S. and international accounting bodies (FASB and IASB) have been working on providing compatible standards and methods of accounting since September 2002, when the bodies’ jointly issued the Norwalk Agreement.
According to FASB, the proposed fair value update issued on May 26, 2010 aims to ensure that fair value will have the same meaning in U.S. GAAP and in IFRS, and that their respective fair value measurement and disclosure requirements will be the same except for minor wording differences. Both boards believe the amendments in this update “will improve the comparability of fair value measurements presented and disclosed in the preparation of financial statements.” The comment period allows stakeholders to weigh in on FASB’s proposed changes to the Accounting Standards Codification (ASC).
How we can help
This is a complicated emerging issue. We can help answer your questions about how to plan and prepare for these changes.
David Legge, Financial Institutions Principal
dlegge@larsonallen.com or 703-825-2135
Jerry Felicelli, Financial Institutions Principal
jfelicelli@larsonallen.com or 239-280-3538
View our financial institution principals.