Financial Markets Insights April 2016 New guidance on recognition and measurement of financial instruments Introduction The FASB recently issued guidance 1 that will impact the recognition and measurement of equity investments, financial liabilities that a company has elected to measure at fair value, and disclosure requirements for financial instruments. Key changes Equity investments Equity investments in unconsolidated entities (except equity method investees) will generally be measured at fair value through earnings. The scope includes equity interests in investment funds (even if they hold principally debt investments) and partnerships. Certain forwards, options, and warrants on equity investments are also in scope if they do not meet the definition of derivative. The available-for-sale classification for equity investments with readily determinable fair values (changes in fair value reported in other comprehensive income or OCI ) and the use of the cost method for equity investments without readily determinable fair values will no longer be available. Companies can elect to record equity investments without readily determinable fair values at cost, less impairment, plus or minus any adjustments for observable price changes for an identical or similar investment of the same issuer (a measurement alternative). 2 Companies will need to qualitatively determine if an investment is impaired each period. If impaired, the company estimates the fair value of the asset. All changes in value will be reported in earnings. Companies will be expected to make a reasonable effort to gather evidence of observable transactions and impairment indicators. Financial liabilities and the fair value option ( FVO ) For financial liabilities where the FVO is elected, the new guidance requires that the changes in fair value due to instrument specific credit risk be recognized separately in OCI rather than earnings. The credit adjustment amounts are reclassified to earnings if the liability is settled before maturity. The updated guidance is not intended to change the accounting for non-recourse liabilities where a company has elected the fair value option to avoid a measurement mismatch with the assets that support them. The new guidance allows companies to measure the change in fair value due to instrumentspecific credit risk based on the portion of the total change in fair value that does not result from a change in a base market risk, such as a risk-free rate or a benchmark interest rate. Overall, the measurement method should be representationally faithful to the objective of determining the change in value attributable to changes in credit risk. 1 Accounting Standards Update 2016-01, Financial Instruments Overall: Recognition and Measurement of Financial Assets and Financial Liabilities. 2 This election is not available for entities that follow specialized accounting models such as broker dealers and investment companies, and does not apply to equity investments that qualify for the NAV practical expedient.
Disclosures Public business entities will have to use an exit price when disclosing the fair value of financial instruments carried at amortized cost but will not have to describe how that fair value is determined. Entities that are not public business entities are no longer required to disclose these fair values. In the footnotes, financial assets and liabilities must be presented separately and grouped by category and form. GAAP vs IFRS Some aspects of the update result in greater convergence between GAAP and upcoming changes to IFRS (IFRS 9). However, certain differences continue to exist for debt investments which were not significantly affected by the new US GAAP guidance. The requirement to measure most equity investments at fair value is generally consistent with IFRS 9. IFRS 9 allows an entity to make an irrevocable election at initial recognition to present subsequent changes in fair value in OCI. The wording in IFRS for the use of cost as a fair value estimate for non-quoted investments is different and may result in different outcomes than the new US GAAP guidance in some cases; albeit their objectives are similar. Under IFRS 9, cost should not be used if there are changes in circumstances or performance, or evidence of value from external transactions. The requirement to present separately in OCI the portion of the total change in fair value of a liability that results from a change in the instrument specific credit risk for financial liabilities measured under the fair value option is consistent with IFRS 9. The IFRS guidance on the type of liabilities that can be measured at fair value differs from GAAP. Additionally, IFRS does not allow amounts recorded in OCI to be recycled to net income upon derecognition of the liability (if settled prior to maturity), whereas this is required under GAAP. Implementation considerations While the new guidance made limited targeted amendments to GAAP and many changes seem straightforward, there are a number of items that companies should consider as they implement these changes, such as: Equity securities The applicability of the new guidance to investments where it is unclear if the instrument is debt or equity based on its legal form, treatment under existing GAAP, or existing static data in a company s systems, System updates needed to record changes in value through current earnings for a greater number of positions, How the measurement alternative is considered in applying other guidance related to fair value measurements, Internal documentation requirements for electing the measurement alternative and factors that could cause a change in its applicability, How to treat FX rate movements on equities under the measurement alternative, Methodologies to adjust observable prices of identical or similar instruments to determine fair value (for example, how to evaluate whether a transaction is orderly and how to consider timing differences between the date of the observable transaction and/or when it becomes known and the reporting date), What factors to consider when determining if a calculation is needed, after qualitatively assessing an instrument for impairment. PwC 2
Instrument specific credit risk Determining the impact of the new guidance for different liabilities considering the various FVO elections available under US GAAP and different levels of recourse, and Developing and documenting the methodologies to apply when measuring instrument specific credit risk, considering the impact of other variables such as FX, interest rates, and the passage of time on the credit risk measurement. Effective date The new standard will be effective for public business entities in fiscal years beginning after December 15, 2017, including interim periods therein. Other entities will apply it in fiscal years beginning after December 15, 2018 and interim periods within fiscal years beginning after December 15, 2019. Early adoption is available for certain provisions and entities. PwC 3
Who can be involved in a continued dialogue? Dave Lukach Partner 646 471 3150 david.m.lukach@pwc.com Marguerite Duprieu Manager 646 471 6857 marguerite.f.duprieu@pwc.com Shannon Detling Director 646 471 5619 shannon.b.detling@pwc.com PwC s Financial Markets Practice brings you: A unique combination of financial reporting, advisory, tax, finance, operational readiness, process and technology, and regulatory expertise, coordinated with specialized transaction and valuation services for securitizations, structured products, derivatives and real estate assets. In-depth knowledge and valuation expertise on virtually all asset classes, including debt and equity securities, derivatives, structured notes, residential and commercial mortgages, mortgage servicing rights, commercial loans and bonds, automobile loans and leases, trade receivables, credit cards, home equity loans, equipment loans and leases, student loans, manufactured housing loans, franchise loans, hospitality and leisure real estate, timeshare receivables, and mutual fund fees. A group of subject matter specialists who provide insights into developments in the capital, credit, derivatives and real estate markets, including but not limited to consumer and corporate credit, investment banking, transaction structures, investor reporting, technology, real estate asset monitoring and management, reorganization and insolvency, forensic accounting and hospitability and leisure services. Expertise in model development and risk analysis to assess your processes for valuing financial instruments, determine robustness of financial models and perform risk analysis, including evaluating sensitivity measures and stress testing methodologies for portfolio risk. Our team is multi-disciplined and diverse. We bring a unique approach to blending and managing services in today s dynamic and fast changing markets. PwC 4
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