Accounting & Auditing

FASB Issues Exposure Draft on Financial Assets & Liabilities

March 2013
Author:  Anne Coughlan

Anne Coughlan

Director

201 N. Illinois Street, Suite 700
P.O. Box 44998
Indianapolis, IN 46244-0998 (46204)

Indianapolis
317.383.4000

On February 14, 2013, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU):  Financial Instruments – Overall (Subtopic 825-10):  Recognition and Measurement of Financial Assets and Liabilities. The proposal would require a new classification and measurement model for all financial assets and liabilities within its scope.

The measurement of financial assets would no longer be dependent on their legal form. Entities would look to an instrument’s characteristics and then its business model to classify financial assets into one of three categories:  amortized cost, fair value through other comprehensive income (FVOCI) or fair value through net income (FVNI). Most financial liabilities would be carried at amortized cost except in the case of a short sale or when the business strategy is to transact at fair value. Most equity investments would be measured at fair value with all changes in fair value recognized in net income. The fair value option for equity method investments would be eliminated. The proposal would replace the unconditional fair value option with a number of conditional fair value options. For financial liabilities where fair value has been elected, changes in value due to changes in instrument-specific credit risk will need to be reported separately in other comprehensive income (OCI) and no longer flow through net income. Not-for-profit entities would retain their portfolio-wide option to account for their equity method investments at fair value. The proposal introduces a one-step impairment model for equity investments. Public companies would be required to disclose the fair value of financial assets and liabilities held at amortized cost.

The public comment period on this proposal ends May 15, 2013; the effective date will be established when the final standard is issued.

Scope

The model would apply to all financial instruments unless they are specifically excluded. Exclusions include derivative hedges, leases, guarantees, insurance contracts and most employer or plan obligations.

Also excluded are regular-way security trades, instruments that are an impediment to sale accounting, certain contracts that are not exchange-traded, e.g., weather contracts, registration payment arrangements, loan commitments held by a potential borrower, instruments held or issued by an entity classified in its entirety in the entity shareholders’ equity, an equity component that has been bifurcated from a hybrid instrument and classified in the entity stockholders’ equity, pledges receivable and payable resulting from voluntary nonreciprocal transfers of not-for-profit entities, equity investments or noncontrolling interests in a consolidated subsidiary and interests in a variable interest entity that the entity is required to consolidate, acquisition-related contracts and contingent consideration arrangements and forward contracts that require physical settlement by repurchase of a fixed number of issuers shares in exchange for cash under topic 840-10-35. 

FASB has retained the following specialized guidance for financial assets held by entities as requirements for doing business rather than for capital appreciation:

  • Investments in Agricultural Cooperatives of Farmers (cost less impairment, equity method)
  • Certain Exchange Memberships of Brokers and Dealers in Securities (cost less impairment, fair value with offsetting liability)
  • Federal Home Loan Bank and Federal Reserve Bank Stock of Banks (cost method)
  • National Credit Union Share Insurance Fund Deposits of Credit Unions (redemption value)

Current GAAP

Under current U.S. generally accepted accounting principles (GAAP), the measurement of a financial asset depends on whether the asset qualifies as a security or a loan. Debt securities are classified into three buckets, and loans are classified into two buckets, using different criteria. Equity securities are classified based on readily available market information. The balance sheet classifications and accounting treatments are highlighted below:

Under the proposal, the classification and measurement of financial assets would be based on both the contractual cash flow characteristics of the financial assets and the entity’s business strategy for those assets. The cost method of accounting would be eliminated for financial instruments.

The proposal groups financial instruments into the following categories:

  • Amortized Cost – held within a business model whose objective is to hold assets to collect contractual cash flows
  • Fair Value Through Other Comprehensive Income (FVOCI) – held within a business model whose objective is both to hold the financial assets to collect cash flows and sell the financial assets
  • Fair Value Through Net Income (FVNI) – residual category; financial assets that fail the business model assessment

Almost all types of financial assets would be eligible for FVNI, but only certain debt investments can be measured at amortized cost or FVOCI. Financial liabilities generally would be measured at amortized cost, unless the business strategy upon initial recognition is FVNI, e.g., an investment bank’s trading portfolio.

Contractual Cash Flow Characteristics Test  

Solely Principal & Interest

A financial asset would be eligible for a measurement category other than FVNI only if the contractual terms of the instrument generate cash flows that are solely payments of principal and interest on the principal amount outstanding. During deliberations, FASB clarified that interest-only strips and zero coupon bonds meet this criteria. If the instrument contains a component other than principal and interest, it must be measured at FVNI, e.g., inverse floaters, index-linked notes and convertible bonds. 

If the instrument only contains principal and interest, but the terms are subject to change (interest rate resets, prepayment or extension options), an entity must consider the effect of the modifications when applying the characteristics test. Such modifications do not preclude an instrument from a measurement category other than FVNI as long as any variability only reflects changes in the time value of money and the credit risk of the instrument. An entity only is required to consider reasonable scenarios in evaluating modifications rather than every possible scenario. If an entity is unable to make a conclusion, the instrument must be measured at FVNI.  

Financial assets containing contingent cash flows that are not solely principal and interest must be measured at FVNI. The ASU implementation guidance provides detailed criteria for application to beneficial interests in securitized financial assets.

The characteristics test only is applied at inception or acquisition and is not revisited. Reclassification is not permitted for subsequent modification of financial instruments. 

Financial assets that fail the characteristics test are classified and measured at FVNI. Equity securities, short sales and derivatives fail the characteristics test and would be accounted for at FVNI. Once a financial asset satisfies the cash flow characteristics criteria, an entity would apply the business model criteria to determine the appropriate classification.

Loan commitments, revolving lines of credit and standby letters of credit would not be required to meet the characteristics test. The issuer would measure the commitment based on the likelihood of the exercise. If the likelihood of exercise is not remote, the issuer would measure the loan commitment consistent with the measurement of the underlying loan. If the underlying loan is measured at FVNI, the loan commitment would be measured at FVNI. If the underlying loan is measured at amortized cost, any commitment fees received would be deferred and recognized over the life of the funded loan as an adjustment of yield. If the likelihood of exercise is remote, the issuer would recognize any commitment fee received as fee income over the commitment period. 

Business Model

The business model assessment only affects debt instruments that pass the characteristics test. Financial assets would be classified at initial recognition (origination or acquisition) into one of three categories based on an entity’s business model. The classification is determined by an entity’s key management on the basis of how the assets will be managed together with other financial assets within a distinct business model. The model is based on objective evidence and business activities for managing financial assets and not management intent. The assessment is performed at a higher level of aggregation, not on an instrument-by-instrument basis. An entity may have more than one business model for managing its financial assets, e.g., example lending, treasury management and trading.

Amortized Cost

Financial assets would qualify for amortized cost if held within a business model whose objective is to hold the assets in order to collect cash flows. Occasional sales are not inconsistent with this objective. An entity may sell if the asset no longer meets investment policy, for funding of capital expenditures or to match duration of assets and liabilities. Sales due to significant credit deterioration would be consistent with this objective if such sales are meant to increase the collection of contractual cash flows through sales rather than cash collection. Sales resulting from managing the credit exposure due to concentration of credit risk would not be consistent with the primary objective of amortized cost. Sales for other reasons should be infrequent. If more than infrequent sales occur, an entity would need to assess whether and how such sales are consistent with the objective to hold to collect contractual cash flows. Assets subsequently identified for sale would not be reclassified and would continue to be measured at cost. Gains or losses from sales would be recorded only when the sale is complete and would be presented separately in the statement of net income with additional disclosures. An entity initially would measure an instrument at transaction cost if it meets the criteria for the amortized cost basis of accounting. 

FVOCI

Financial assets classified as FVOCI may be held for collection of contractual cash flows or sold. Management may hold the assets for an unspecified period of time or sell the assets to meet certain objective. An entity initially would measure an instrument at transaction cost if it meets the criteria for the FVOCI basis of accounting. 

Not-for-profit (NFP) entities generally do not report net income or other comprehensive income. NFPs within the scope of Topic 954 may report a performance indicator comparable to net income. These NFPs would report items classified as FVOCI outside the performance indicator. All other NFPs would report the change in the fair value of a financial instrument as a change in the appropriate net asset class in its statement of activities.

FVNI

This is the residual bucket for instruments not meeting the criteria for amortized cost or FVOCI. This includes assets held for sale at initial recognition or actively managed and internally monitored on a fair value basis. At acquisition, entities would measure these instruments at fair value; any transaction fees or costs would be included in net income. 

Reclassifications

If the business model changes, an entity prospectively would reclassify its financial assets. This is expected to happen very infrequently. Such a change in business model must be determined by senior management, significant to the entity’s operations, a result of external or internal changes and must be demonstrable to external parties. A temporary disappearance of a market would not constitute a change in an entity’s business model. 

Equity Securities

Investments in equity securities, including those that do not meet the criteria for equity method accounting and those that do not have a readily determinable fair value, are to be measured at FVNI. Equity securities previously classified as available-for-sale with changes in fair value recognized in other comprehensive income would be measured at FVNI. FASB approved a practical exception for nonmarketable equity securities. If elected, entities would record those securities at cost less impairment adjusted for observable price changes. Equity investments in entities in which the investor has significant influence may be eligible for the equity method of accounting.

Equity Method of Accounting

The current guidance for determining if an equity investment should be accounted for under the equity method of accounting based on the existence of significant influence will be retained. The proposal eliminates the fair value option, and an entity would be required to classify and measure equity investments that otherwise would qualify for the equity method of accounting at FVNI if the investment is held for sale. An entity would perform a held-for-sale evaluation upon the investment’s initial qualification for the equity method of accounting, and the entity could not subsequently change the classification of the investment. An equity method investment would be considered held for sale if an entity has either a specifically identified potential exit strategy or a defined timing for its expected exit.

FASB retained the industry specific guidance in ACS 958-325-35, Not-for-Profit Entities Investments-Other-Subsequent Measurement, which allows not-for-profits to carry all other investments at fair value or cost/equity method under an explicit portfolio-wide election to use fair value. This guidance covers both financial instruments such as equity ownership interests without readily determinable market values and nonfinancial instruments such as real estate. This avoids a situation where a not-for-profit would be forced to restate any fair-valued equity securities held as part of an endowment to the equity method due to the elimination of the fair value option. 

Impairment of Equity Method Investments

An entity would apply a single-step impairment approach for equity method investments in which the entity assesses qualitative factors to determine whether an equity method investment is impaired. The proposed guidance eliminates the other-than-temporary impairment model for equity investments accounted for under the cost method and for those subject to the equity method of accounting. A single impairment model would be applied to both marketable and nonmarketable equity method investments. An impairment charge for the difference between the carrying amount and the fair value would be recognized in net income when an entity determines it is more likely than not that the fair value of the investment is less than its carrying amount. Impairment charges cannot be reversed for subsequent recovery in value.

Financial Liabilities

An entity would measure financial liabilities at amortized cost unless the entity’s business strategy at acquisition is to subsequently transact at fair value or if the financial liabilities are short sales. If either criterion is met, the financial liabilities would be classified as FVNI.

Nonrecourse Liabilities

Financial liabilities that can only be settled with specified financial assets and do not have other recourse are required to be measured consistently with those specified assets. For example, beneficial interests in a securitization that only can be settled using the cash flows from the debt investments held in the securitized entity would be measured consistently with those debt investments held in the entity. If the debt investments are carried at amortized cost, the beneficial interest also would be carried at amortized cost and written down for the same impairment charge as recognized on the assets.

Hybrid Financial Instruments

Hybrid financial assets would be classified and measured in their entirety. Under current U.S. GAAP, a hybrid financial asset (with a debt instrument host) that contains an embedded derivative is accounted for separately from the financial instrument host contract. Under the proposed model, the entire instrument would be evaluated under the instrument characteristic criteria and accounted for as a single instrument. In most cases, the embedded derivatives features that would be separated under current guidance would cause the entire instrument’s cash flows to not be considered solely the payment of principal and interest, resulting in the instrument being measured at FVNI. 

For hybrid financial liabilities, an entity would first apply the bifurcation and separate accounting analysis (as required under Topics 815, 470 and 480) on whether to separate the hybrid instrument into its derivative and non-derivative components before applying the proposed model. Only a financial liability host or a debt-equity hybrid instrument recognized as a financial liability in its entirety or as having a separately reportable financial liability component would be classified and measured in accordance with the tentative model.

Hybrid Nonfinancial Instruments

The proposal eliminates the fair value option that permits an entity to measure at fair value a host financial instrument resulting from the separation of an embedded nonfinancial derivative from a nonfinancial hybrid instrument. A hybrid nonfinancial asset that contains an embedded derivative requiring bifurcation and separate accounting under Subtopic 815-15 would be measured in its entirety at fair value, with changes in fair value recognized in earnings.

For a hybrid nonfinancial liability, an entity would apply the bifurcation and separate accounting requirements in Subtopic 815-15 and account for the embedded derivative in accordance with Topic 815. The financial host resulting from separation of the nonfinancial embedded derivative would be subject to the tentative model. At initial recognition, an entity would be permitted to initially and subsequently measure the hybrid nonfinancial liability at fair value (with changes in fair value recognized in earnings) if, after applying Subtopic 815-15, an entity determines that an embedded derivative that requires bifurcation and separate accounting exists.

Fair Value Option for Financial Instruments

The proposal eliminates the need for a fair value option because the proposal allows an entity to elect to measure any financial instrument at FVNI, including instruments that meet the criteria for FVOCI. Other assets or liabilities currently eligible for the fair value option under Topic 825 that are excluded from the scope of the proposal would continue to be eligible for the fair value option.

Changes in Fair Value Attributable to Changes in “Own Credit”

Changes in fair value that result from a change in a reporting entity’s own credit risk for financial liabilities would be recognized and presented separately in OCI. Cumulative gains and losses recognized in OCI associated with changes in own credit will be recognized in net income upon the settlement of the liability. The entire risk in excess of a base market risk, such as a risk-free interest rate, would be considered as the change in own credit or an alternative method that an entity deems as a more faithful measurement of such a risk.

Financial Statement Presentation

Statement of Financial Position

An entity would be required to separately present financial assets and financial liabilities on the statement of financial position by classification and measurement category.

Financial Assets & Financial Liabilities Measured at Amortized Cost

Only public entities would be required to parenthetically present on the face of the statement of financial position the fair value for financial assets and financial liabilities except for demand deposit liabilities (which are measured at cost). Receivables and payables due in less than a year would not be subject to the parenthetical disclosure of fair value.

All entities, both public and private, would be required to separately present cumulative credit losses on the face of the statement of financial position.

Financial assets qualifying for the amortized cost category at initial recognition that are subsequently identified for sale will be presented in a separate line item on the face of the statement of financial position.

Financial Liabilities Measured at Fair Value

All entities would be required to parenthetically present on the face of the statement of financial position the amortized cost of an entity’s own debt that is measured at fair value.

Equity Method Investments

Equity method investments held for sale would be presented in a separate line item on the face of the statement of financial position.

Statement of Comprehensive Income

Financial Assets

An entity would be required to present, in net income, an aggregate amount for realized and unrealized gains or losses for financial assets measured at FVNI.

An entity would be required to separately present the following items in net income for both financial assets measured at FVOCI and financial assets measured at amortized cost:
1.  Current-period interest income
2.  Current-period credit losses
3.  Realized gains and losses

Financial Liabilities

An entity would be required to present, in net income, an aggregate amount for realized and unrealized gains or losses for financial liabilities measured at FVNI.

An entity would be required to separately present the following items in net income for financial liabilities measured at amortized cost:
1.  Current-period interest expense
2.  Realized gains and losses

Disclosures

Financial Instruments Measured at Amortized Cost

An entity with financial instruments that are measured at amortized cost for which fair value information is parenthetically presented on the statement of financial position would disclose the following about the fair value information:

1.  The level of the fair value hierarchy within which the fair value measurements are categorized in their entirety (Level 1, 2 or 3)
2.  For items within Level 3 of the fair value hierarchy, quantitative information about the significant unobservable inputs used in the fair value measurement
3.  For items within Level 2 and Level 3 of the fair value hierarchy, a description of the valuation technique(s) and the inputs used in the fair value measurement
4.  A description of the changes in the method(s) and significant assumptions used to estimate the fair value of financial instruments, including the reason(s) for making the change, if any, during the period
5.  For items within Level 3 of the fair value hierarchy, a description of the valuation processes used by the reporting entity, including, for example, how an entity decides its valuation policies and procedures and analyzes changes in fair value measurements from period to period

An entity that has sold financial assets that were carried at amortized cost would disclose the following:
1.  The net carrying amount of the asset(s) sold
2.  The net gain or loss in accumulated OCI for any derivative that hedged the forecasted acquisition of the amortized cost security
3.  The related realized gain or loss on asset(s) sold
4.  The circumstances leading to the decision to sell the asset(s)
5.  The amortized cost basis, fair value and unrealized gain or loss on asset(s) subsequently identified for sale

Financial Assets Classified at FVOCI

An entity with financial assets classified at FVOCI would disclose the amortized cost basis of the assets, fair value of the assets, total gains for financial assets with net gains in accumulated OCI and total losses for financial assets with net losses in accumulated OCI.   

An entity that has sold financial assets classified at FVOCI would disclose the following:
1.  Proceeds from sales and the gross realized gains and gross realized losses that have been recognized in earnings as a result of those sales
2.  The amount of the net unrealized holding gain or loss on assets for the period that has been included in accumulated OCI and the amount of gains and losses reclassified out of accumulated OCI into earnings for the period

Reclassification Due to a Change in Business Model

If any assets were reclassified due to a change in an entity’s business model, an entity would disclose the date of reclassification, the reason for the change, a qualitative description of its effect on the entity’s financial statements and the amount reclassified into and out of each category.

Core Deposit Liabilities

Public entities would disclose on an annual basis the following, disaggregated by significant types of core deposit liabilities, e.g., demand deposits and savings accounts:
1.  The core deposit liability balance
2.  The implied weighted-average maturity period
3.  The estimated all-in-cost-to-service rate

Nonpublic entities would not be required to provide disclosures about their core deposit liabilities.

Non-Marketable Equity Securities  

Entities that apply the practicability exception to fair value measurement for investments in non-marketable equity securities would disclose the following:

1.  The carrying amount of equity securities that the entity concludes are non-marketable
2.  The amount of any impairments and upward and downward adjustments, both annual and cumulative
3.  As of the date of the most recent statement of financial position, additional information (in narrative form) that provides sufficient information to allow financial statement users to understand the quantitative disclosures and the information the entity considered (both positive and negative) in reaching the carrying amounts and upward or downward adjustments

Nonrecourse Financial Liabilities

An entity with nonrecourse financial liabilities would disclose the following:

1.  Qualitative information about the relationship between financial assets and the nonrecourse financial liabilities that will be used to settle them and the line items where they are reported
2.  The carrying amounts of the financial liabilities and related financial assets that will be used to settle the nonrecourse financial liabilities

Financial Liabilities Measured at Fair Value Under the Fair Value Option

For changes in fair value due to changes in own credit risk (applicable to financial liabilities for which an entity has elected the fair value option), an entity would disclose the following:
1.  The amount of change, during the period and cumulatively, in the fair value of the financial liability that is attributable to changes in the instrument-specific credit risk
2.  How the gains and losses attributable to changes in instrument-specific credit risk were determined
3.  If a liability is settled during the period, the amount (if any) presented in OCI that was realized in net income at settlement

Transition Guidance & Disclosures

An entity would apply the tentative model to all outstanding instruments as of the effective date and record a cumulative-effect adjustment to beginning retained earnings as of the beginning of the first reporting period in which the guidance is effective.

Early Adoption

Early adoption would not be permitted, except for the requirement to present separately in OCI the changes in fair value that result from a change in a reporting entity’s own credit risk for financial liabilities that are designated under the proposed fair value option and measured at FVNI.

If you have additional questions, please contact your BKD advisor.

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