Many institutions classify debt security portfolios as held to maturity when they have the positive intent and ability to hold those securities to maturity. The advantage of this classification is that temporary changes in the fair value of these securities are not recognized in the financial statements, removing unnecessary volatility in other comprehensive income. However, if institutions change their intent to or can no longer hold even one security to its contractual maturity, generally the entire portfolio is “tainted” and must be reclassified as available for sale.
A recent accounting standard has given institutions a one-time opportunity to reclassify qualifying securities from held to maturity to available for sale.
Under existing accounting standards, when a financial institution no longer has the intent or ability to hold a security to maturity, this taints management’s intent and ability to hold the entire portfolio of securities held to maturity so that the entire portfolio must be reclassified except when there is:
- Evidence of a significant deterioration in the issuer's creditworthiness (for example, a downgrading of an issuer's published credit rating).
- A change in tax law that eliminates or reduces the tax-exempt status of interest on the debt security (but not a change in tax law that revises the marginal tax rates applicable to interest income).
- A major business combination or major disposition (such as sale of a component of an entity) that necessitates the sale or transfer of held-to-maturity securities to maintain the entity's existing interest rate risk position or credit risk policy.
- A change in statutory or regulatory requirements significantly modifying either what constitutes a permissible investment or the maximum level of investments in certain kinds of securities, thereby causing an entity to dispose of a held-to-maturity security.
- A significant increase by the regulator in the industry's capital requirements that causes the entity to downsize by selling held-to-maturity securities.
- A significant increase in the risk weights of debt securities used for regulatory risk-based capital purposes.
- A security sale within three months of its maturity date (or call date if exercise of the call is probable).
- A security sale after the institution has already collected at least 85 percent of the principal outstanding at acquisition.
Other events that cause an institution to sell a security held to maturity would not taint the institution’s intent to hold other debt securities to maturity if they meet all of the following conditions:
- The event is isolated.
- The event is nonrecurring.
- The event is unusual for the reporting entity.
- The event could not have been reasonably anticipated.
However, ASC 320-10-25-10 states that other than extremely remote disaster scenarios (such as a run on a financial institution or an insurance entity), very few events would meet all four of those conditions.
Consequently, if an institution changes its intent or no longer has the ability to hold one or more securities held to maturity, it will usually have to reclassify the entire portfolio. After such a reclassification occurs, judgment is required to determine when circumstances have changed such that management can assert with a greater degree of credibility that it has the intent and ability to hold debt securities to maturity. In other words, an institution cannot reclassify securities and then begin classifying new securities as held to maturity right away.
Opportunity to Reclassify Qualifying Securities
In Accounting Standards Update (ASU) No. 2017-12, Targeted Improvements to Accounting for Hedging Activities, the Financial Accounting Standards Board (FASB) gave all entities an opportunity to reclassify securities held to maturity without tainting the rest of the portfolio if they are eligible to be hedged using the “last-of-layer method.” Note that the securities need not be hedged but simply eligible to be hedged. Debt securities are eligible to be hedged using the last-of-layer method if they are prepayable. This could mean the issuer is able to prepay or call a portion or all of the principal balance prior to the contractual maturity.
An institution may elect to reclassify such securities from held to maturity to available for sale only when the institution adopts the ASU. ASU No. 2017-12 may be adopted by an institution for any interim period, although the adoption will be effective as of the beginning of the annual period of adoption. Public business entities must adopt the standard for fiscal years beginning after
December 15, 2018, and all other entities must adopt it for fiscal years beginning after
December 15, 2019.
Institutions may have several reasons to reclassify securities, but the primary reason is to provide liquidity. Recently, many institutions have considered reclassification because of the Current Expected Credit Loss (CECL) rule. CECL will apply to securities held to maturity but will not affect securities available for sale. As a result, institutions are considering reclassifying securities so they do not have to worry about applying CECL to their securities portfolio.
This ASU will give an institution a chance to reclassify selected securities without tainting its entire portfolio; however, here are some things to consider if an institution is thinking about reclassifying securities because of CECL:
- It is likely the institution will want to reclassify all securities held to maturity, which an institution can do at any time.
- Since a private institution has some time before it must adopt ASU No. 2017-12, I would recommend waiting a little while. We might find that the application of CECL to securities held to maturity isn’t as burdensome as we think today.
If an institution is looking to reclassify prepayable securities from held to maturity, this may be a chance to do so without tainting the remaining portfolio.
If you have any questions about which securities can be reclassified under ASU No. 2017-12 or when the reclassification can and should happen, please contact your Wipfli relationship executive.