FASB Proposes Expansion of Fair Value

In its long awaited proposal issued last week, the FASB has expanded fair value accounting to nearly every financial asset. Companies have until September 30 to comment on the new proposal. We expect this proposal to generate a large volume of comments from companies that hold loans, core deposit liabilities, and derivatives for investment or risk management purposes. In addition to expanding the need for subjective estimates of fair value, the FASB is also proposing to simplify derivatives accounting by reducing the need for embedded derivative bifurcations. Even better, they are proposing the elimination of regression analysis and quarterly hedge effectiveness testing for many highly effective hedges through the introduction of a “reasonably effective” concept. Any company that holds financial assets that are not already subject to fair value accounting requirements is affected by this proposal, especially financial institutions that hold loans and non-public equity securities. Understanding this proposal will help you determine your accounting position and whether to send comments to the FASB. This alert will also explain the new OCI election and help you prepare for any changes in your use of fair value accounting. SUMMARY Last week the FASB issued its Proposed Update on financial instrument accounting. The proposal covers most financial instruments, with limited exceptions related to leases, insurance and pensions. Highlights of the 218 page proposal include:

• Most financial assets will be measured at fair value with periodic changes in fair value reported in earnings or other comprehensive income (OCI)
• An OCI election whereby changes in fair value are recorded in OCI rather than earnings
• To the relief of many CFOs, hedge accounting would be streamlined
• One impairment model for all financial assets

Interestingly, although the FASB and the IASB are working so closely together to align new rules, the proposal actually requires more fair value accounting than recent proposals issued by the IASB. Small non-public companies may qualify for a four year adoption deferral only for certain loans, commitments and core deposits, but the rest of the rule would have to be adopted on time, including the new disclosures. IMPLEMENTATION Most financial instruments will be reported on the balance sheet at fair value. There would be some exceptions for short-term receivables and payables, certain investments and a company’s own debt. Changes in fair value will flow through earnings unless a company elects OCI treatment and meets the following criteria:

• The company’s overall strategy (cannot be based on intent for a given instrument) is to receive or pay cash flows, not sell or settle with a third party
• The instrument is debt (held or issued) with the following characteristics:
  • A principal amount is transferred at the beginning and returned at maturity or settlement
  • Interest or other cash flows to be paid are explicitly identified in the terms
  • The instrument cannot be prepaid or settled such that the investor would not get back most of their investment
• If the debt contains an embedded derivative, it must be clearly and closely related to the host contract

Core deposit liabilities will be recognized using a present value measurement, with changes in fair value recognized in net income or OCI. The OCI election would need to be made at the date of adoption and would be irrevocable. The equity method of accounting will still be used if an investor has significant influence, but only if the investment is deemed related to the investor’s business. The fair value election option will no longer be available if the investment is subject to equity-method accounting. Such investments not within scope would be fair valued with changes reported in earnings. IMPAIRMENT Under current rules, companies are required to evaluate credit losses for financial instruments that aren’t marked-to-market through earnings, as well as certain receivables measured at amortized cost and certain investments measured at redemption value. In performing this evaluation, companies are allowed to consider credit event probability scenarios. For example, impairment testing for loans would be very similar to what we have now for securities. The concept of “probable” would no longer be used in estimating credit losses. Instead, companies would recognize credit impairment whenever there is an indication that they won’t be unable to collect all cash flows. The new rule would also require interest income to be recognized by multiplying the amortized cost less cumulative credit impairments by the effective interest rate. Upon transition, companies will record the cumulative effect adjustment on the balance sheet prior to the final rule’s effective date. Early adoption will not be permitted. The result of these changes would be an earlier recognition of credit losses and the recognition of less interest income when credit impairments have been taken. DERIVATIVES AND HEDGING For the first time since FAS 133 was issued in 1998, derivative and hedge accounting would be greatly simplified as follows:

• Subject to exceptions and limitations, embedded derivatives would no longer be bifurcated from their host contract. The entire contract would be fair valued through earnings
• Hedges previously subject to “highly effective” effectiveness testing would now be assessed in terms of whether the hedging relationship is “reasonably effective”
• No more short-cut method or critical terms match concept. Instead, companies can use “reasonable effectiveness” in many cases.
• No more mandatory quarterly reassessments. Hedges would be reassessed only if circumstances suggest that the hedging relationship may no longer be reasonably effective
• No more hedge de-designation prior to maturity. De-designation would only occur if the hedge is not reasonably effective, or if the derivative is terminated with the counter party.

Under the proposal, hedge effectiveness testing accounting would be more straightforward and more hedges would qualify for hedge accounting. Hedges that can be demonstrated to be reasonably effective would no longer be subject to extensive regression analysis. CONCLUSION Having more financial instruments reported at fair value means increased scrutiny by preparers, auditors and regulators. This especially applies to loans, non-public equity securities and other instruments that are not held for trading. Increased volatility in earnings and OCI will need to be carefully evaluated so that appropriate OCI elections may be made. If you would like to explore further how Pluris can assist you in responding to the proposal or evaluating your financial instruments, we invite you to contact us at 212.248.4500 in New York or 650.485.4049 in California, or to email us at rmartin@pluris.com.