Get Ready For an Overhaul of Financial Instruments Accounting

The FASB is expected to take action soon on an accounting standards update (ASU) that represents a complete overhaul of the recognition, measurement and presentation of financial instruments, such as stocks and bonds. A financial instrument can be cash, evidence of an ownership interest in a company, or a contract that imposes an obligation on one party, while conveying a right to another. The obligation and right can pertain to the deliverance of cash or other financial instruments. Since financial institutions typically hold large amounts of financial instruments, they are likely to be most affected by the proposed changes. Broadly speaking, affected financial institutions would include retail banks, investment banks, insurance companies, and private equity firms, and the ASU would apply equally to both public companies and private companies that report under U.S. GAAP. However, any company with a portfolio of securities will be affected. Proposed changes that will have a major impact on the ways companies manage, value, structure and account for financial instruments were released by the FASB on February 14. Comments on the proposed new rules were due May 15. The FASB received many comments on the proposed changes, but it is too early to determine what will be included in the final rule. Read on to find out how the proposed changes will affect you if they pass as proposed. Under the ASU, cash flow characteristics and a company’s business model would replace management intentions and the legal form of the instrument in determining classification. Financial assets would initially be classified into one of three buckets:

• Fair value through net income (FV-NI)
• Fair value through other comprehensive income (FV-OCI
• Amortized cost

Reclassifications between categories would be rare and only allowed if there is a change in the business model. Any reclassification would be recorded on the last day of the reporting period. Under current rules, financial assets are classified as available-for-sale, trading or held-to-maturity, and reclassification may occur as frequently as management intentions change. If the proposal is passed, every company will need to evaluate the way its accounting systems collect and report information in the new categories. Internal audits pertaining to financial instruments will need to be revamped, and the underlying controls will need to be redefined. Specific Treatment for Marketable Equity Securities If the proposal becomes effective, investments in marketable equity securities will be classified as FV-NI, unless the investment qualifies for the equity method of accounting or the company is permitted to elect a practicability exception at initial recognition. Even if the instrument qualifies for the equity method of accounting, investments in equity securities will still be accounted for at FV-NI if they are being held for sale, unless the practicability exception was elected at initial recognition. Any investments that qualify for the equity method that are not accounted for as FV-NI will be evaluated for impairment under a single-step approach, doing away with the other-than-temporary impairment recognition threshold. Under current rules, there is a FV-OCI option available for equity investments. Non-Marketable Equity Securities The proposal introduces a new valuation methodology for non-marketable equity securities. Under the proposal, companies would be permitted to measure non-marketable equity investments using an approach that starts with the instrument’s cost basis and then adjusts that amount for any observable change in price changes. Under current rules, historical cost is not considered in determining fair value as of the measurement date. There is a distinction between illiquid securities and non-marketable securities, although an instrument can be both illiquid and non-marketable. Illiquid securities may be freely exchanged, but trades occur infrequently and trading volume is low. Non-marketable securities are limited by design, in that they cannot be sold either for a certain period of time or for the life of the instrument. Companies will need to review their investment portfolios to specifically identify non-marketable securities. Investments in Debt Instruments Classification of investments in debt instruments such as loans, receivables and investments in debt securities, would be based on the instrument’s cash flow characteristics and the business model used for managing the instrument. If the cash flow characteristics provide for anything other than solely principal and interest payments, they would be classified as FV-NI. FV-NI would also apply to loans held for sale. If payments are solely principal and interest, the business model will determine which of the three categories applies. This is a big change under current practice for loans. Under current rules, management intentions and the legal form of the instrument form the basis for classification. Changes in management intentions would no longer influence initial classification, nor would they drive subsequent reclassification. The legal form of a document would also no longer serve as support for classification. This represents a significant change from current practice. For example, some financial instruments have characteristics of both loans and securities, and it’s difficult to determine how they should be classified. Under current rules, many financial institutions evaluate these instruments based on their legal form. Under the proposal, the business model and cash flows would be the determining factors. Example: Convertible Debt Under current rules, issuers must separately account for the liability and equity components of convertible debt. The issuer must value the liability component by measuring the fair value of a comparable security. Embedded features, such as put and call options, must be taken into account in determining fair value. An issuer computes the carrying amount of the equity component of the convertible instrument by subtracting the value of the liability component from the initial proceeds. The issuer then must allocate transaction costs proportionately between the liability and equity components. Under proposed rules, while it is possible to structure the cash flow characteristics of a convertible debt instrument to provide solely for principal and interest payments, the business models of both the issuer and holder must also encompass an expectation of a possible conversion to equity. From both the holder's and issuer's perspectives, both the liability and equity components are likely to end up with FV-NI, depending on how the instrument is structured. Amortized Cost The proposed amortized cost bucket is similar to today’s held-to-maturity category with respect to restrictions on sales. The concept of “tainting” the portfolio by selling out of amortized would not apply, although additional disclosures would be required. Bifurcation of Embedded Derivatives in Financial Assets Under current rules, an embedded derivative is generally bifurcated from its host contract and accounted for separately if the embedded feature is not considered to be clearly and closely related to the host contract. The rationale behind this rule is that if market conditions that influence the embedded feature are significantly different from those that affect the host contract, the embedded feature should be treated as if it is its own instrument. For example, if an equity host has an embedded derivative that goes up and down in value depending on what interest rates do, it will be bifurcated. Under the proposal, embedded derivatives in financial assets would no longer be bifurcated from their hybrid financial asset host contract, whereas embedded derivatives in financial liabilities would continue to be bifurcated. Fair value election option The fair value option as we know it will be removed and replaced with a far more restrictive set of criteria. The fair value election option would no longer be available for equity method investments. If the fair value election is opted for a company’s own credit, changes in fair value due to changes in a company’s own credit would be recorded in OCI rather than net income. Also, if the proposed rules are approved:

• Financial liabilities will be classified at amortized cost, unless the liability is a short sale, it meets the definition of a derivative or the company plans to sell it at fair value.
• FV-OCI will no longer be used as a “default” measurement category; FV-NI will be the new default category.
• Foreign-currency gains and losses on debt instruments that are classified as FV-OCI will be recognized in net income, except for investment companies. Under current rules, foreign currency gains and losses are booked into income when realized, not based on their classification.
• Fair value will need to be disclosed on the face of the balance sheet for assets and liabilities classified in amortized cost.

The likelihood that these rules will become effective substantially as proposed is unknown, but they are controversial. Companies are likely to have concerns over the business model and cash flow characteristics tests, as well as the lack of an FV-OCI option for equity instruments.  One board member of the FASB, Thomas Linsmeier, has been outspoken in his support of the role of fair value accounting under current rules. Contact Pluris today to discuss how these changes, if put into effect, will impact the valuation and accounting of your financial assets and liabilities.