GAccounting for Financial Instruments – Audit and Accounting Guide Depository and Lending Institutions, 2nd Edition

Appendix G
Accounting for Financial Instruments

This appendix is nonauthoritative and is included for informational purposes only.

Overall Project Objective

The objective of FASB’s Accounting for Financial Instruments project is to significantly improve the decision usefulness of financial instrument reporting for users of financial statements. The project was initiated to reconsider recognition and measurement of financial instruments, address issues related to impairment of financial instruments and hedge accounting, and increase convergence in accounting for financial instruments. In replacing the existing financial instruments standards, an expected outcome is the simplification of the accounting requirements for financial instruments. The project was split into three phases including classification and measurement, impairment, and hedge accounting. This appendix focusses on the latest developments in each of these phases.

Classification and Measurement

Overview

On January 5, 2016, FASB issued Accounting Standards Update (ASU) No. 2016-01, Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, to enhance the reporting model for financial instruments and to provide users of financial statements with more decision-useful information. The amendments in the ASU are intended to improve certain aspects of recognition, measurement, presentation, and disclosure of financial instruments.

The new guidance will accomplish the following:

  • Require equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income
  • Replace the impairment model for equity investments without readily determinable fair values with a qualitative impairment assessment
  • Eliminate the requirement to disclose the fair values of financial assets and financial liabilities measured at amortized cost for entities that are not public business entities
  • Eliminate the requirement for public business entities to disclose the methods and significant assumptions used to estimate fair value that is required to be disclosed for financial assets and financial liabilities measured at amortized cost on the balance sheet
  • Require public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes
  • Require an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments
  • Require separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (that is, securities or loans and receivables) on the balance sheet or the accompanying notes to the financial statements
  • Clarify that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to available-for-sale debt securities in combination with an entity’s other deferred tax assets
  • Eliminate an entity’s ability to estimate the disclosed fair values of financial assets and financial liabilities on the basis of entry prices

Applicability and Effective Date

ASU No. 2016-01 affects all entities that hold financial assets or have financial liabilities and is effective as follows:

Fiscal Years Beginning After Interim Periods Within Fiscal Years Beginning After
Public business entities December 15, 2017 December 15, 2017
All other entities, including not-for-profit entities and employee benefit plans within the scope of FASB Accounting Standards Codification (ASC) 960–965 on plan accounting December 15, 2018 December 15, 2019

All entities that are not public business entities may adopt the amendments in this ASU earlier as of the fiscal years beginning after December 15, 2017, including interim periods within those fiscal years.

Early application by public business entities to financial statements of fiscal years or interim periods that have not yet been issued or, by all other entities, that have not yet been made available for issuance of the following amendments in this ASU are permitted as of the beginning of the fiscal year of adoption:

  • An entity should present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk if the entity has elected to measure the liability at fair value in accordance with the fair value option for financial instruments.
  • Entities that are not public business entities are not required to apply the fair value of financial instruments disclosure guidance in the "General" subsection of FASB ASC 825-10-50.

With the exception of this early application guidance, early adoption of the amendments in this ASU is not permitted.

Impairment

Overview

On June 16, 2016, FASB issued ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. Upon the effective date of this ASU, the incurred loss impairment methodology in current general accepted accounting principles (GAAP) is replaced with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates.

Assets Measured at Amortized Cost

ASU No. 2016-13 eliminates the probable initial recognition threshold under current GAAP and requires entities that measure financial assets (or a group of financial assets) at amortized cost basis to present such assets at the net amount expected to be collected. The amendments in this ASU broaden the information that an entity must consider in developing its expected credit loss estimate for assets measured either collectively or individually. In addition to past events and current conditions, entities should also consider reasonable and supportable forecasts that affect the collectibility of the reported amount. However, an entity may revert to historical loss information that is reflective of the contractual term (considering the effect of prepayments) for periods that are beyond the time frame for which the entity is able to develop reasonable and supportable forecasts.

An entity may apply any method for measuring expected credit losses as long as their method reasonably reflects its expectations of the credit loss estimate.

Purchased Financial Assets With Credit Deterioration

ASU No. 2016-13 defines purchased financial assets with credit deterioration (PCD assets) as acquired individual financial assets (or acquired groups of financial assets with similar risk characteristics) that as of the date of acquisition have experienced a more-than-insignificant deterioration in credit quality since origination, as determined by the acquirer’s assessment. The allowance for credit losses for PCD assets that are measured at amortized cost basis is determined in a similar manner to other financial assets measured at amortized cost basis. The initial allowance for credit losses is added to the purchase price, rather than being reported as a credit loss expense. Entities record only subsequent changes in the allowance for credit losses as a credit loss expense for PCD assets. Furthermore, an entity should recognize interest income for PCD assets based on the effective interest rate, excluding the discount embedded in the purchase price that is attributable to the acquirer’s assessment of credit losses at acquisition.

Disclosures

In an effort to increase users’ understanding of underwriting standards and credit quality trends, ASU No. 2016-13 requires the current disclosure on credit quality indicators in relation to the amortized cost of financing receivables to be further disaggregated by year of origination (or vintage). Entities that are not public business entities are not required to disclose the disaggregation by year of origination.

Available for Sale Debt Securities

Entities will now be required to present credit losses on available-for-sale debt securities as an allowance, rather than as a permanent write-down.

An entity will now be able to record reversals of credit losses on debt securities (in situations in which the estimate of credit declines) in current period net income. Thus, aligning the income statement recognition of credit losses with the reporting period in which changes occur. However, an entity may not record an allowance for credit losses exceeding the amount by which fair value is below amortized cost.

Purchased Debt Securities With Credit Deterioration

The allowance for credit losses for purchased available-for-sale debt securities with a more-than-insignificant amount of credit deterioration since origination is also determined in a similar manner to other available-for-sale debt securities. However, ASU No. 2016-13 requires an entity to add the initial allowance for credit losses to the purchase price, rather than reporting it as a credit loss expense. Entities record only subsequent changes in the allowance for credit losses as a credit loss expense. Furthermore, an entity should recognize interest income based on the effective interest rate, excluding the discount embedded in the purchase price that is attributable to the acquirer’s assessment of credit losses at acquisition.

Troubled Debt Restructurings

The ASU does not change the definition or derecognition guidelines for troubled debt restructurings (TDRs), but, rather, changes the impairment recognized on restructuring. Credit losses for TDRs now will be measured using the current expected credit loss model. The ASU eliminates the current GAAP requirement to use a discounted cash flow technique. Credit losses, including concessions given to a borrower under a TDR, will be recognized through an allowance account.

Applicability and Effective Date

ASU No. 2016-13 affects entities holding financial assets and net investment in leases that are not accounted for at fair value through net income. It also affects loans, debt securities, trade receivables, net investments in leases, off-balance sheet credit exposures, reinsurance receivables, and any other financial assets not excluded from the scope that have the contractual right to receive cash.

Because there is diversity in practice in applying the incurred loss methodology, ASU No. 2016-13 will affect entities to varying degrees depending on the credit quality of the assets held by the entities, their duration, and how the entity applies current GAAP.

ASU No. 2016-13 is effective as follows:

Fiscal Years Beginning After Interim Periods Within Fiscal Years Beginning After
Public business entities that are SEC filers December 15, 2019 December 15, 2019
All other public entities December 15, 2020 December 15, 2020
All other entities, including not-for-profit entities and employee benefit plans within the scope of FASB ASC 960–965 on plan accounting December 15, 2020 December 15, 2021

All entities may adopt the amendments in this ASU earlier as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.

Transition Resource Group

Due to the potential for significant changes that may result from the issuance of the new standard, FASB has formed the Transition Resource Group (TRG) for Credit Losses to

  • solicit, analyze, and discuss stakeholder issues arising from implementation of the new guidance.
  • inform FASB about those implementation issues, which will help FASB determine what, if any, action will be needed to address those issues.
  • provide a forum for stakeholders to learn about the new guidance from others involved with implementation.

The TRG will meet to discuss and share their views on potential implementation issues raised by concerned parties and, subsequent to each meeting, FASB will determine what actions, if any, will be taken on each issue. Refer to the page "Transition Resource Group for Credit Losses" on FASB’s website for more information on this group and the status of their efforts, including meeting materials and meeting summaries.

Hedge Accounting

Overview

Hedge accounting is the third phase in FASB’s overall project on accounting for financial instruments. The objective of this project is to make targeted improvements to the hedge accounting model based on the feedback received from preparers, auditors, users, and other stakeholders. FASB has also noted it will consider opportunities to align with IFRS 9, Financial Instruments.

Latest Developments

FASB staff are drafting a proposed ASU based on the tentative decisions reached by the board. Readers are encouraged to visit the "Technical Agenda" page under "Projects" at www.fasb.org for the latest developments regarding the hedge accounting phase.

Conclusion

The extent of the effect of the new financial instruments standards will depend upon the relative significance of financial instruments to an entity’s operations and financial positon as well as the entity’s business strategy. To provide CPAs with guidance during this time of transition, the AICPA’s Financial Reporting Center (FRC) offers invaluable resources on the topic. In addition, the FRC includes a list of conferences, webcasts, and products to keep you informed on the latest developments in accounting for financial instruments. Refer to http://www.aicpa.org/InterestAreas/FRC/AccountingFinancialReporting/FinancialInstruments/Pages/default.aspx to stay updated on the latest information available on accounting for financial instruments.

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