On January 5, the Financial Accounting Standards Board (FASB) published its accounting standard that changes how to recognize and measure financial assets and liabilities. Banks and other companies with holdings in financial instruments — such as loans, debt securities and financial liabilities — have been closely monitoring the FASB’s controversial three-phase project on financial instruments for nearly a decade.
Fueled by the financial crisis, this project initially sought to overhaul accounting for complex financial instruments. But phase one, on recognition and measurement, keeps most U.S. Generally Accepted Accounting Principles (GAAP) related to financial instruments intact, except for some “targeted improvements.”
Minor low-cost changes
Accounting Standards Update (ASU) No. 2016-01, Financial Instruments — Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, requires equity investments that aren’t measured under the equity method of accounting to be measured at fair value with changes recorded in earnings.
The updated standard also eliminates the counterintuitive — and much-criticized — provision in existing GAAP that allows banks to record gains in earnings when the value of their liabilities declines because of a drop in credit quality. Banks and other businesses will keep those fluctuations out of earnings and be required to record what is known as “own credit risk” in other comprehensive income.
In addition, the updated standard changes some disclosure requirements. Public companies have to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. But private companies and not-for-profit groups can skip a requirement to disclose the fair value of financial instruments measured at amortized cost. The standard also eliminates the requirement for public companies to disclose the methods and significant assumptions used to estimate the fair value that’s required to be disclosed for financial instruments measured at amortized cost.
Finally, the updated standard calls for separate presentations of financial assets and financial liabilities by measurement category and form of financial asset, such as securities or loans and receivables, on the balance sheet or the accompanying notes to the financial statements.
The good news is that the FASB predicts that “the direct costs of applying this update are likely to be minimal and may even decrease for certain organizations.”
The long and winding road
The end result isn’t as comprehensive as the FASB envisioned a decade ago when it began working with the International Accounting Standards Board to overhaul the measurement of complex financial assets and liabilities. The effort took on heightened importance during the 2008 financial crisis, when it became clear that banks and other businesses were using increasingly risky financial instruments — and that the accounting for them hadn’t kept pace.
Unfortunately, the standard-setters never were able to fully agree on how to change the accounting standards. Years of internal debate, two harshly criticized public proposals and pressure from U.S. banks, which argued that the boards were going to make accounting more complex, made the FASB retreat in early 2014.
Most FASB members acknowledged that the last proposal before the final standard was issued, Proposed ASU No. 2013-220, Financial Instruments — Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities, called for many complex accounting changes that would largely bring businesses to the same results as current U.S. GAAP. So, in a 4-3 split vote, the board decided to largely maintain the status quo.
Dissenting FASB members said the updated standard failed to meet the board’s intended goals:
- Improving the usefulness of reported information,
- Reducing complexity in accounting for financial instruments, and
- Converging U.S. GAAP and International Financial Reporting Standards.
To critics, the update represents a lost opportunity for real change. Current accounting often is criticized because similar financial instruments are measured in different ways depending on what management intends to do with them. Critics argue that this intent-based focus gives investors, creditors and analysts too little information about how the instruments are performing.
Time for change
For public companies, the updated guidance in ASU 2016-01 becomes effective for annual periods starting after December 15, 2017. So, public companies should begin applying the changes in their first-quarter filings for 2018.
Private companies have the option of adopting the standard as of the effective date for public companies. But they get an extra year before compliance is required for their annual financial statements.
Sidebar: More guidance on financial instruments coming soon
The Financial Accounting Standards Board’s (FASB’s) recent standard on recognizing and measuring financial instruments is the first phase of a three-part project. Phase two on financial instrument impairment, also known as the credit loss standard, is expected to be published in late March. But first, the FASB has agreed to hold a roundtable in February to address the concerns of community bankers.
Impairment occurs when the fair value of a financial instrument falls below the amount reported on the company’s balance sheet. Based on the 2012 Proposed Accounting Standards Update 2012-260, Financial Instruments — Credit Losses (Subtopic 825-15), banks would be required to look to the foreseeable future, consider all losses that could happen over the life of a loan, trade receivable or security in question, and immediately book losses.
Under the existing guidance, banks are required to record losses only after they’re “probable.” In practice, this often means after the losses have occurred. In the months leading up to the 2008 financial crisis, many bank balance sheets appeared healthy even as the mortgage market melted down.
Both large and small banks have expressed concerns about how to follow the new “current expected credit loss” model because the FASB doesn’t offer a specific way to calculate potential future losses. Others worry that the standard would require new, expensive models and processing systems. The Independent Community Bankers of America (ICBA), a coalition of small banks, estimates the immediate recording of a provision for credit losses would result in a 30% to 50% increase in loan loss reserves.
The ICBA is pressuring the FASB to provide exceptions for small banks. But, during a recent speech, FASB Chairman Russell Golden affirmed his commitment to creating a uniform standard for banks and holding companies of all sizes. Because more than 160 community banks failed during the financial crisis, Golden concluded, “Clearly, community banks have been part of the problem.”
Phase three of the financial instruments project will address improvements to the hedge accounting model. The FASB also expects to issue an exposure draft on this narrow-scope guidance in the first quarter of 2016.