ACCOUNTING FOR FINANCIAL INSTRUMENTS Comparison of FASB Exposure Draft and IASB Final Standard/Exposure Drafts. Issue FASB IASB Current GAAP

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1 Issues included in project framework One Exposure Draft covering: 1. Loans/securities/liabilities 2. Impairment (reserving) 3. Hedge accounting Separate Exposure Drafts covering: 1. Loans/securities (now final IFRS 9) 2. Impairment (reserving) 3. Hedge/liability accounting 4. Fair Value Option for certain financial liabilities. Loan and Securities Accounting Is loan accounting the same as debt securities accounting? Yes. Yes. No. FAS 115, FAS 65, FAS 141R, SOP 03-3, EITF are examples of different guidance for different instruments and in different situations. What classification buckets are there? 1. Fair Value (FV), with changes thru net income (FV/NI). 2. Amortized Cost. Same as FASB Loans 1. HFS: LOCOM 2. HFI: Amortized Cost 3. Purchased with credit impairment: Expected cash flows. 4. Purchased impaired loans: Expected cash flows or FV of collateral. 5. TDR: Expected cash flows or at FV of collateral. Securities 1. Trading: FV, with changes thru net income 1 P a g e

2 2. AFS: FV, with changes thru OCI 3. HTM: Amortized Cost 4. EITF securities: Expected cash flows. What does amortized cost mean? Income is based on effective yield, after consideration of the loss reserve (see below). However, the FV is recorded on the balance sheet and changes in FV go thru OCI. Income is based on effective yield, after consideration of loss reserve (see below). However, interest income, both before and after considering the expected losses will be presented on the income statement. No FV changes are recorded. Income is based on effective yield before the consideration of a loss reserve. No FV changes are recorded. What are the criteria for loans and debt securities to be accounted for at amortized cost? 1. If an entity s business strategy is to hold assets in order to collect contractual cash flows, rather than to sell or settle with a third party, changes in FV may be recognized in OCI, rather than NI. No loans or debt securities can be accounted for at amortized cost on the balance sheet. 1. Business model is to hold for the collection of contractual cash flows, and 2. Terms of the instrument give rise to cash flows that are solely payments of principal and interest. Management intent is: 1. Loans: To hold for the foreseeable future. 2. Debt Securities: To hold to maturity. 2 P a g e

3 Is there tainting of a portfolio that could result in the whole portfolio or similar securities being marked to market? No. However, reclassifications between classification buckets are not allowed. Realized gains/losses of amortized cost assets are expected to be listed separately by maturity date and holding period. No. However, reclassifications between classification buckets are not allowed. Yes. For example, sales of HTM securities may result in fair value for similar securities not sold, with changes recorded to net income for similar securities or an entire portfolio. Sales of AFS securities that have experienced OTTI can, in some circumstances, result in a tainting of the AFS portfolio and the OTTI that is recorded in OCI. From a FAS 115 view, the new buckets equate to: Trading and AFS. Trading and HTM (prior to recent FSP that put market-related OTTI into OCI). How are embedded derivatives treated? In circumstances when the derivative would be bifurcated under current GAAP, the whole contract is now recorded at FV. If the derivative is clearly and closely related to the host contract, it may be recorded at amortized cost. The derivative and the host contract are always considered as one. If the entire contract does not meet the definitions above for amortized cost accounting, it must be recorded at FV, with changes recognized thru net income. Embedded derivatives not clearly and closely related to the host contract may be bifurcated from the host and accounted for separately at fair value, with changes recorded thru net income, while the host contract is accounted for at amortized cost. If not bifurcated, the whole contract is accounted for at fair value, with changes recorded thru net income. 3 P a g e

4 ABA Observations The requirement to record all loans at FV will significantly impact bank equity. Although tainting of a portfolio will not exist, the lack of ability to reclassify assets may cause more MTM thru earnings. Certain banks that originate loans both to sell and to hold may run into circumstances where MTM thru earnings may be required. For example, if expected sales of loans fall through, the loans may be required to be held and accounted for at FV/NI. While not designed to increase MTM, the IASB model will likely result in more MTM for a number of banks. Specific circumstances include: Lower tranches of CMOs/CDOs whose credit risk is higher than the weighted average of the credit risk of the structure in total is automatically at FV, with changes thru net income (FV/NI). Holdings of interests in complex CDOs where a look through of the underlying asset is impractical will require FV/NI. Certain securities with embedded derivatives may require automatic FV/NI. Although tainting of a portfolio will not exist, the lack of ability to reclassify assets may cause more MTM. Certain banks that originate loans both to sell and to hold may run into circumstances where MTM may be required. For example, if expected sales of loans fall through, the loans may be required to be held and accounted for at FV/NI. 4 P a g e

5 Presentation of Financial Statements How are assets that are accounted for at amortized cost presented on the balance sheet? Amortized Cost less loss reserve, plus/minus FV adjs Amortized cost only. Fair values for are in footnote disclosures. Amortized cost only. Fair values are in footnote disclosures. = FV How is the Statement of Income presented? One Statement of Comprehensive Income is required. OCI will now be shown below net income on the same schedule, summing to Total Comprehensive Income. One Statement of Comprehensive Income is required. OCI will now be shown below net income on the same schedule, summing to Total Comprehensive Income. Statement of comprehensive income may be shown separately. OCI per share will not be shown. OCI per share will not be shown. ABA Observations With the requirement for one statement of comprehensive income, the FV changes for loans and securities that are recorded in OCI will effectively run through to the new bottom line. The IASB is expected to consider whether parenthetical or other disclosure on the balance sheet will be required for fair values of loans and other amortized cost assets. 5 P a g e

6 Impairment Measurement How are loan loss reserves to be calculated? Loss recorded is based on expected credit losses, based on all available information relating to past events and existing conditions and their natural implications to the collectability of the financial assets. Hard triggers (events that cause the loss) and probability thresholds are removed from the current standards. Loss reserve is recorded based on expected cash flows over the life of the asset, applying the effective interest rate. The effective interest rate at inception is adjusted by deducting future expected credit losses. FASB Statement 5 requires a loss to be recorded when probable and estimable. Because of how those terms have been interpreted over the years, this has often been interpreted to mean, how much a bank is expected to write-off in the next months. No Day 1 losses are allowed. Can expectations of the future be considered in expectations? Future expectations are not to be considered unless a past event will reasonably result in that future event. An announcement of a future factory closing is an example. Future expectations are implied, since the specific timing of the cash flows must be projected. This allows the present value calculation to be made. Future expectations are not allowed. In FASB terms: An entity would consider the implications of past events and existing conditions beyond the date of the financial statements Is there a Day 1 Loss? Historical loss data may indicate a No Day 1 loss would be recognized. However, subsequent increases in 6 P a g e

7 Day 1 loss is required. impairment are recognized straight through earnings. How is interest income accrued? The effective interest rate is determined prior to the allowance for loan losses. However, interest is accrued only on the amortized cost, less the allowance.. The effective interest rate is based on the net, after allowance, investment. Interest income is recognized per FASB 91, based on the contractual rate, adjusted for the net fees collected, including any purchase premiums and discounts. ABA Observations Though it will present operational challenges, it initially appears that the methodology to calculate loan loss reserves is more operational than that of the IASB. A Day 1 loss does not reflect how banks normally do business, however, as loans are generally issued with no expectation of default. However, when determining the allowance, banks may use loss ratios based on a current book of business that may effectively create a small day 1 loss. The requirement to calculate the effective interest rate after (not before) impairment will provide significant operational challenges. The requirement to estimate cash flows thru the life of the asset presents operational challenges that are significant. In essence, this amounts to a FAS 114 cash flow approach for the entire portfolio. Bankers appear to be able to perform this on a very limited basis, but not for the entire portfolio. Those banks that have acquired impaired loans and must estimate cash flows in accordance with SOP 03-3 have experienced significant operational difficulties in performing this process. The requirement to calculate the effective interest rate after (not before) impairment will provide significant operational challenges. 7 P a g e

8 Other Assets and Liabilities How are equity securities to be accounted for? All non-consolidated equities are at FV, with changes thru earnings. Certain equities may be assigned to have changes in FV recorded thru OCI. All others are FV. Realized gains and losses for FV-OCI securities are not recorded thru net income, but are reclassified as an adjustment to retained earnings. Equity Securities are recorded in various ways, depending on the marketability of the security and the stake held: Cost method: Equity securities with market values NOT readily determinable. Equity method: Equity securities that represent a significant (generally between 20 and 50%) share of the investee entity. FAS 115 for equity securities with readily determinable market values: Trading: FV, with changes thru net income AFS: FV, with changes thru OCI. Holdings in FHLB stock are at par, with a review for impairment. How are liabilities to be accounted for? Debt liabilities may be allowed amortized cost in certain situations. Financial liabilities are recorded at amortized cost. Unless the Fair Value Option is elected, liabilities are generally recorded at amortized cost. 8 P a g e

9 Core deposit intangibles will be estimated using a present value of the average core deposit amount discounted by the difference between the alternative funds rate and the all-in-cost-to-service rate over the implied maturity. Is the Fair Value Option available? Not applicable, since the default measure of financial assets and liabilities is fair value. There is a fair value option at initial recognition. Gains and losses on fair value for these liabilities are reflected on the income statement, but then the portion of gain/loss that is due to changes in the bank s own credit rating are backed out and then recorded to other comprehensive income. These are amount are not recycled, meaning they never go through net income. May be elected at management s discretion. ABA Observations Measurement of a core deposit intangible is intended by FASB to address the concern of mismatching of interest rate movement from fair valuing loans. (Note that it is not a fair value measurement, but an internal estimate). However, the way it is defined, it still does not address the various points of value that are The requirement to significantly reduce measurement inconsistency may introduce operational issues consistent with current hedge accounting requirements. 9 P a g e

10 not reflected in the fair value of an individual loan. An example is the impact of a customer relationship (e.g. credit card receivables) on future lending and non-lending (services) business. The FASB s concern about permitting the core deposit intangible to be at full fair value is because the CDI is an intangible asset and not a financial asset. Therefore, it technically is not included in the scope of the project. 10 P a g e

11 Hedge Accounting and Scope Deferral How will hedge accounting change? 1. Qualitative (rather than quantitative) test at inception is required to demonstrate an economic relationship exists. 2. Hedging instrument must be reasonably effective in offsetting changes in the hedged item. To be determined. Complex rules and documentation requirements prevent many banks from using hedge accounting. Hedge accounting currently differs based on whether the hedge is a fair value hedge, a cash flow hedge, or a foreign currency hedge. 3. Effectiveness is reassessed only if circumstances indicate the hedging relationship is no longer reasonably effective. 4. Shortcut and critical terms match methods eliminated. 5. Hedge acctg may be discontinued only if criteria for hedge accounting are no longer met. No arbitrary dehedge accounting. 6. Particular risks may be hedged. Does not need to be the whole instrument. 11 P a g e

12 Scope Deferral FASB defers the requirements of classification and measurement to non-publicly held institutions with assets less than $1 billion for four years. These institutions will, however, be required to calculate the FAS 107 fair value disclosures in accordance with FAS 157 exit price rules. ABA Observations The deferral will scope out approximately 95% of banks in the U.S. Although smaller banks will not be required to comply for four years, the FAS 107 disclosure requirement now presents a costly and time consuming process. Smaller banks will also be required to implement the impairment processes without deferral. With this in mind, the deferral appears to apply more to presentation than to the operational challenges. 12 P a g e