The Financial Accounting Standards Board (FASB) has finalized the first standard to emerge from its longstanding financial instruments project. This project began around 2005 as a joint project with the International Accounting Standards Board (IASB) to improve and achieve convergence of their respective standards on the accounting for financial instruments. Eventually, the project was divided into three separate financial instrument projects: classification and measurement, impairment, and hedging.
The project started out by proposing to make substantial changes to the measurement of financial instruments, suggesting that most financial instruments should be measured at fair value. In the end, Accounting Standards Update (ASU) No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, requires relatively minor adjustments to the classification and measurement of certain financial instruments.
Equity investments with readily determinable fair values will no longer be classified as available for sale. This available-for-sale classification currently presents changes in unrealized gains and losses on such investments as other comprehensive income. Going forward, changes in fair value of equity investments with readily determinable fair values will be recognized in net income similar to the current “trading” classification. Institutions may choose to measure equity investments that do not have readily determinable fair values (other than equity-method and consolidated investments) at:
- Fair value (following the same guidance in the previous paragraph); OR
- Most likely, at cost minus impairment, if any, plus or minus changes in observable market values resulting from orderly transactions for the identical or a similar investment of the same issuer.
For example, if an institution owns a small amount of nonpublic stock in another entity and the institution subsequently observes the purchase of that same stock by a willing market participant, the institution will adjust the reported value of its own investment up or down based on the observed market transaction. This differs from current rules that do not allow for observed increases in market value to be recognized by the institution. Observed changes in fair value will be recognized in net income.
Investments accounted for under the equity method or result in consolidation accounting are generally unaffected by this standard.
ASU No. 2016-01 also simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment. When such an assessment indicates impairment exists, the institution would measure its investment at fair value.
The new standard provides some relief regarding the requirement to disclose the fair value of financial instruments measured at amortized cost in the balance sheet. Current accounting rules require all financial institutions that prepare financial statements under accounting principles generally accepted in the United States (GAAP) and that are over $100 million in total assets, are public entities, or have derivative instruments (other than rate lock commitments) to disclose the fair value of all financial instruments, including those that are measured at amortized cost, such as loans held for investment. These are often referred to as the “FAS 107 disclosures.”
ASU No. 2016-01 removes the requirement to make the FAS 107 disclosures for institutions that do not meet the definition of a public business entity. This specific provision may be adopted early for any financial statements that have not been issued. Consequently, institutions preparing GAAP financial statements today can already remove this disclosure from their financial statements.
For public business entities that still have to present the FAS 107 disclosures, the new standard will remove the requirement to disclose the methods and significant assumptions used to estimate the fair value of financial instruments measured at amortized cost in the balance sheet. Unfortunately, this provision cannot be adopted early.
Other accounting changes resulting from the new standard include the following:
- Requirement that public business entities must use the exit price notion when measuring fair value of financial instruments in the FAS 107 disclosures.
- Clarification that institutions should evaluate the need for a valuation allowance on a deferred tax asset related to securities available for sale in combination with the institution’s other deferred tax assets.
- Requirement for separate presentation of financial instruments by category and form of instrument on the balance sheet or in the accompanying notes.
- Requirement for institutions that have elected the fair value option for a financial liability to present changes in the fair value of the financial liability resulting from changes in the institution’s credit risk as a separate component of other comprehensive income.
ASU No. 2016-01 will be effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. For other entities, the standard is effective for fiscal years beginning after December 15, 2018, and interim periods after that year. Entities that are not public business entities may adopt this standard no earlier than the effective date for public business entities. However, the following provisions may be adopted as of the beginning of any fiscal year for which financial statements have not been issued or made available to be issued:
- Ability to remove the FAS 107 disclosures for nonpublic business entities.
- If the fair value option has been adopted for a financial liability, the requirement to present changes in fair value of that financial liability related to changes in the institution’s own credit risk in other comprehensive income.
The accounting changes resulting from ASU No. 2016-01 are relatively minor compared to the initial FASB proposal, and some of the changes, like the removal of the FAS 107 disclosure requirement, will be viewed as positive by most institutions. If you have any questions on how this standard will impact your institution, please contact Brett Schwantes or your Wipfli relationship executive.