Accounting Standards Update (ASU) 2016-01, Recognition and Measurement of Financial Assets and Liabilities, introduces new guidance that impacts accounting for equity investments. The guidance applies to most equity investments, including investments in equity securities, and will require an entity to measure equity securities with a readily determinable fair value at fair value through net income.
In general, financial institutions have limited investments in equity securities. However, some financial institutions may hold equity securities for specific purposes, such as to fund employee benefit liabilities. Other entities hold equity securities at the holding company level. Under ASU 2016-01, these equity securities can no longer be classified as available-for-sale securities. Instead, market value fluctuations on equity securities will have to be recognized directly through net income. Consequently, this new standard will result in increased income statement volatility for entities holding equity securities.
An entity may elect to value equity investments without a readily determinable fair value at its cost minus impairment (if any) plus or minus changes resulting from observable price changes in orderly transactions for the identical or similar investment of the same issuer, with any changes recognized through net income. If electing this alternative, an entity would be expected to make efforts to identify relevant observable transactions that are known or can reasonably be known, but the entity is not required to spend undue cost and effort to identify such transactions.
Practically speaking, the new standard will require a financial institution to adjust its reported value of certain equity investments that have historically been reported at cost on the balance sheet, such as stock in Bankers’ Bank, based on observable price changes from orderly stock transactions. For example, if an entity had purchased 50 shares of Bankers’ Bank stock in a previous period at $500 per share, it would have an asset recorded of $25,000, assuming no impairment had been recorded. In the current year, the entity observes that a peer institution sold a similar issue of Bankers’ Bank stock in an orderly transaction for $2,000 per share. Under ASU 2016-01, the entity would need to adjust the value of its Bankers’ Bank stock based on the observed, orderly transaction. As a result, it would increase the value of its Bankers’ Bank stock asset to $100,000 and recognize a $75,000 gain through the income statement. The entity would be expected to make reasonable efforts to identify additional observable transactions in future periods.
ASU 2016-01 is effective for public business entities for years beginning after December 15, 2017, and for non-public business entities beginning December 15, 2018. In the year of adoption, entities will make a cumulative-effect adjustment to reclassify unrealized gains and losses from securities available for sale in accumulated other comprehensive income to beginning retained earnings. If the institution has made the special accounting election for investments without readily determinable fair values, any changes to an investment’s balance will be recognized prospectively in net income (rather than as an adjustment to retained earnings). The guidance in this standard will not impact the measurement of Federal Home Loan Bank or Federal Reserve Bank stock.
ASU 2016-01 is a wide-reaching standard that impacts accounting and disclosures of various financial assets and liabilities. Please reach out to your Wipfli relationship executive if you have additional questions.