On January 5, 2016, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The ASU’s effective date is quickly approaching for public business entities1; the standard is effective for fiscal years beginning after December 15, 2017, including interim periods, i.e., March 2018 for calendar year-end companies. While many of the ASU’s provisions are straightforward and likely won’t require significant preparation, other provisions likely will require some additional lead time. One such provision relates to fair value disclosures for financial instruments carried at amortized cost.
U.S. generally accepted accounting principles (GAAP) currently allow entities an option to measure fair value in two different ways for disclosure for certain financial assets. Entry price represents the buyer’s perspective—what a company would pay to acquire an asset or settle a liability. Exit price reflects the seller’s standpoint—what a company would receive if it were to sell the asset in the marketplace or be paid if it were to transfer the liability.
The current exception in Accounting Standards Codification (ASC) 825, Financial Instruments, allowing entities to use an entry price notion rather than the exit price notion of ASC 820, Fair Value Measurement, is superseded by ASU 2016-01. Going forward, only the exit price will be permitted. Therefore, depending on the current model used to determine the fair value of certain financial assets, changes to the model will be necessary. The most likely change needed for financial institutions relates to the fair value computation of loans.
Most financial institutions use data generated from their asset/liability software to determine fair value. While this information captures the interest rate component of the fair value adjustment (an entry price notion), it doesn’t appropriately capture the credit quality component. With current GAAP, the allowance for loan losses is recorded based on a probable/incurred model; therefore, the allowance doesn’t appropriately represent the credit quality component needed for computation of fair value at an exit price notion.
Companies may be able to address this issue using a variety of approaches. Some approaches include:
- Use of a third-party valuation specialist to value the loan portfolio. This valuation would be similar to the valuations obtained to record fair value adjustments in a business combination.
- Determine if changes can be made to the asset/liability model to incorporate the necessary credit quality assumptions to bring the fair value to an exit price notion.
- Determine the availability and reliability of industry data that could provide the necessary information to supplement the current fair value computation.
With the effective date less than a year away for public business entities, now is a good time to begin developing a game plan.
Contact your BKD advisor for more information, or visit BKD’s Hot Topics page to learn more.
1 A public entity is defined as any one of these:
A public business entity
- A not-for-profit entity that has issued, or is a conduit bond obligor for, securities traded, listed or quoted on an exchange or over-the-counter market
- An employee benefit plan that files or furnishes financial statements to the U.S. Securities and Exchange Commission