Financial Instruments Where are we? Recognition and Measurement Impairment Derivatives

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1 Financial Instruments Where are we? Recognition and Measurement Impairment Derivatives Susan Cosper Kirk Silva Mark LaMonte Robert Uhl

2 Financial Instruments Needs Fixing? FASB issued a new standard on recognition and measurement that makes targeted improvements rather than major changes (ASU ) FASB is almost done with its new standard on credit losses which will introduce a new model FASB will also be issuing a new proposal for derivatives and hedging to simplify and improve What about convergence? Not quite! 2

3 Classification and Measurement FASB dropped their plans previously proposed to make major changes (e.g., more fair value) (Those ideas got little support) The targeted amendments for modest improvements for financial instruments relate to: Measurement of equity investments Presentation of changes in fair value of company s own debt under the fair value option Dropping certain fair value disclosures for non-public companies 3

4 First, What s not Changing! Classification of debt securities Although major changes were proposed, the current framework was retained and it is still OK to use the three buckets: Trading carry at fair value with changes through net income Available for sale carry at fair value with changes through other comprehensive income (but consider need for impairment). (Note an amendment has been made regarding recording deferred taxes) Hold to maturity Carry at amortized cost (but consider need for impairment) 4

5 The Improvements Equity Investments Today available for sale category -carry at FV with changes in value through OCI (unless impaired) GONE! New Approach Equity securities carried at FV BUT changes in value will be recorded directly in income (There is also a measurement alternative for calculating FV). This does not apply to equity securities that are accounted for under the equity method or are consolidated but it does apply to partnerships, JV s and limited liability companies. 5

6 Measurement Alternative An Election! For equity securities without a readily determinable fair value, investors may elect to measure the securities at cost, less impairment, plus or minus observable price changes (in orderly transactions) of an identical or similar investment of the same issuer. Impairment (when using the exception) No longer will it be necessary to assess whether the impairment is other than temporary. Instead, review a list of qualitative indicators (e.g., investee is incurring losses) and reach a subjective conclusion on whether the investment is impaired. If it is, write down the equity investment to fair value through income a one step approach (rather than two). 6

7 FV Option Company s Own Debt Today if the fair value option is elected, all changes in value are recorded in income. Odd Result if company s own credit rating goes way down (bad), the FV of its debt goes down, and this gives rise to income! Hard to explain! New Approach the company s debt will still be recorded at fair value under the option BUT the portion of the change in value due to changes in the company s own credit risk will be recorded in other comprehensive income (an improvement!). Disclose how the OCI portion was calculated. 7

8 Disclosures Relief is being given to non public entities. They are no longer required to make fair value disclosures of investments carried at amortized cost. Public companies will be able to disclose less fair value information for investments carried at amortized cost (e.g., information on methods and assumptions used in determining fair value will not be required). Other disclosure requirements have been changed as well. 8

9 What About Convergence? FASB and IASB could not quite agree so the IASB issued their own financial instrument standard (IFRS 9, amended). For example, in IFRS 9, debt securities can be carried at cost only if the instrument simply calls for principal and interest payments. More complex financial instruments (e.g., embedded derivatives) carry at fair value through income. Not too much overall convergence! 9

10 Effective Date and Transition for Classification and Measurement Public companies calendar Y/E s (and interim periods) beginning 1/1/18 Non-public companies calendar Y/E s beginning 1/1/19 and interim periods beginning 1/1/20 Early adoption permitted but only for fair value option and the reduced disclosures for non-public companies. Transition Cumulative effect as of the beginning of the year adoption is required, through retained earnings (not retrospective). However, for equity securities without readily determinable fair values and for certain of the fair value disclosure requirements, transition is prospective. 10

11 How to Recognize Impairment Problem for loans and securities too little, too late. A big change should be final soon! The new idea (from both FASB and IASB) The incurred loss probable approach (FASB ) will be gone! The goal is to recognize Expected Credit Losses but FASB and IASB approaches are different (so much for convergence). 11

12 Current Expected Credit Loss Model CECL The new FASB approach will apply to all financial assets (not just held by financial institutions) that are measured at amortized cost. It is applicable to financial assets such as loans and commitments, debt securities (held to maturity), trade receivables, lease receivables. Impact for amortized cost financial assets - recognize the current estimate of all expected credit losses sooner! 12

13 Incurred loss model gone! Expected Losses The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial assets to present the net amount expected to be collected. But how do you estimate what the expected lifetime credit losses will be? 13

14 FASB Guidance Entities may leverage their existing processes, but may need to modify inputs to reflect expected credit losses rather than asset s reported amount. Use not only historical experience and assessment of current conditions but also reasonable and supportable forecasts that affect the expected collectability of the asset s remaining contractual cash flows. There is additional guidance on what to do for the period after this reasonable and supportable period ends i.e., revert to unadjusted historical credit loss experience for such future periods. Practicable? Auditable? Will the Transition Resource Group help? 14

15 Other Changes Available for sale debt securities carried at fair value through OCI use a modified version of the current other than temporary impairment model (not the CECL model) except: Use allowance approach instead of write off that could be reversed Don t consider subsequent events or length of time fair value has been under cost New guidance on purchased financial assets with credit deterioration referred to as PCD s New guidance for troubled debt restructurings 15

16 Modified Disclosures Credit quality disclosures consistent with existing GAAP Policies for estimating expected credit losses Period-to-period roll forward of allowance Vintage year disclosures No relief for non-public companies 16

17 Effective Date and Transition Effective date 1/1/2019 for SEC filers, later for other entities. (Note Just revised to 1/1/2020 allowing early adoption on 1/1/2019). Transition Generally by a cumulative effect adjustment as of the beginning of the year adopted but some requirements for prospective transition (such as PCD assets and AFS securities previously impaired). Disclosures will be required of the impact. What about implementation issues? 17

18 Obtaining historical credit loss data Implementation Issues Developing reasonable supportable forecasts about the future (community banks have particular concerns) Adjusting historical data to reflect forecasted information New disclosures operational? PREPARATION SUGGESTIONS? And what did the IASB do about impairment? 18

19 IASB s Three Buckets Model A Taste! Bucket #1 Loans without significant deterioration, initially record only losses expected to occur in next year. If credit quality significantly deteriorates move down to Bucket #2 or #3. For Bucket #2 (groups) or #3 (individual), now record losses expected over the entire life of the loan, not just one year. This has already been issued in 2014 (in IFRS 9). Europe is not applying it yet. FASB concluded this bucket approach would retain thresholds for when to record credit losses and would not be practical to implement thus the world has two different expected loss models! 19

20 Derivatives and Hedging Financial and Nonfinancial Items (Codification 815) The New Proposal - will be issued very soon? Goal targeted improvements to the hedging model (simplification?) FASB has been trying for many years now and hedge accounting has been the source of many practice issues - perhaps FASB will finally improve the model and actually make it easier to apply for preparers and more understandable for users. FASB is trying to align with IFRS No. 9 (a bit of convergence). 20

21 A taste of proposed improvements Various changes are being proposed. These include 5 categories: 1. Overall hedge accounting model - Initial quantitative testing required unless certain can use shortcut or critical terms match qualitative methods can be used to assert perfect effectiveness. Subsequent effectiveness testing only necessary if facts and circumstances change. More flexibility in timing of initial quantitative test (when needed) documentation needs. Changes for hedging components of nonfinancial risk (commodity risk). 2. Changes in FV of derivatives designated as hedges No longer will have to split between effective and ineffective portions. Guidance on where to display FV changes. (Also see 5 below.) 3. Hedging benchmark interest rate risk For variable rate financial instruments (cash flow hedges), can designate the contractual variable interest rate as the hedged risk, no longer requiring the use of the benchmark interest rate or overall cash flows. This change would not apply for hedges of fixed rate financial instruments. 21

22 More hedging proposals 4. Fair value hedges of interest rate risk To determine changes in FV of the hedged item, use either benchmark component of cash flows or total coupon cash flows. Partial term hedging revised to allow principal repayment at the end of hedge period. Would be able to hedge just a portion of the term of the financial instrument as the hedged risk. 5. Cash flow and net investment hedges Qualifying investment hedges the entire change in FV of the hedging instrument included in the assessment would be recorded in OCI (for cash flow hedges) or as part of the cumulative translation adjustment (for net investment hedges). OPEN - Issuance of proposal - soon, Effective date, and Transition 22

23 Summary Views Will these financial instruments projects ever end? How should companies start to get ready? Will FASB have to provide more implementation guidance? Is there hope for further convergence? Q & A s 23

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