The fourth panel of the 15th Annual Financial Reporting Conference assessed the status of recognition and impairment of financial instruments in light of FASB’s new standard, Accounting Standards Update (ASU) 2016-01, as well as upcoming standards on credit losses and derivatives and hedging.

The Project

Norman Strauss first called on Robert Uhl, who noted that the overall financial instrument project had changed in scope over the years: “At first the thought was, fair value would be the best measurement for all financial assets. As FASB did their outreach, they heard some dissension.” Eventually, he said, FASB settled on more modest modifications to the classification and measurement standards.

Mark LaMonte then detailed the changes to equity investments, which are significant. “Historically,” LaMonte said, “equity securities could be treated as available for sale, with the gains and losses being recorded in other comprehensive income [OCI]. The new standard requires that equity investments be marked through the P&L [profit-and-loss statement].” This change has the potential to create volatility for companies with many equity investments, such as insurance companies. LaMonte noted that international standards still allow OCI treatment in certain cases, which could cause difficulties for some issuers. LaMonte noted, “It’s in the eye of the beholder whether or not it’s a good idea. Certainly from a user perspective, volatility can drive us a little nuts. But for firms that are in the business of holding investments, like an insurer, volatility is real, so this it will better portray their true operating results.”

Cosper then detailed the process for measuring equity investments for which fair value cannot be readily determined, which will be done at cost less impairment, adjusted for subsequent observable price changes for identical or similar investments. “Those changes will be reported in current earnings,” she explained. She added that, while elective, the measurement should be applied consistently from period to period.

Cosper also discussed the simplified impairment test. “It’s a simplified, single-step test,” she said, “where you look at a qualitative assessment, and the guidance includes some impairment indicators. When it does exist, the impairment’s based on the fair value less the carrying value.” The streamlined test will, FASB hopes, be simpler for issuers to apply. Cosper clarified that the rule applies to both public and nonpublic companies.

Strauss returned to Uhl to discuss the new fair value option for recording debt. Uhl noted that the traditional method leads to a paradoxical result where, as a company’s credit goes down, it records a gain. To remedy this, he said, “FASB has decided that when you’re fair valuing your debt, you would take that piece that’s due to your own credit and put that into OCI.” Companies have a great deal of latitude in determining the amount due to their own credit, he added, but those methods must be disclosed. He also emphasized that this standard only applies to debt that companies elect to recognize under the fair value option.

LaMonte added that the new option “is a positive change” that eliminates a non-GAAP measure and “the need for investors to make adjustments.” He also commented on the general trend towards disclosure relief: “Some of the information that is going away is information that we use, so there is a bit of a negative.”

Strauss then turned to Kirk Silva to discuss whether there was convergence between FASB and the International Accounting Standards Board (IASB) on this topic. “At one point, both FASB and the IASB were proposing the same model.” While this approach seemed simple, Silva remarked that “there was a realization that we were just swapping one model for another and getting the same conclusions. So from the perspective of a preparer, we were quite satisfied that FASB listened to feedback and instead went in the direction of targeted changes.”

“At first the thought was, fair value would be the best measurement for all financial assets. As FASB did their outreach, they heard some dissension.” Eventually, Uhl said, FASB settled on more modest modifications to the classification and measurement standards.

Cosper outlined the transition dates for the standard. Public companies must adopt the standard in 2018, while non-public companies adopt in 2019 for annual statements and 2020 for interim statements. Companies can also early adopt certain provisions.

New Credit Loss Model: CECL

Strauss then turned to LaMonte to explain the new credit loss model. LaMonte began by explaining that the 2008 financial crisis brought many weaknesses in the old model to light. “We saw banks that were basically bleeding losses for bad loans that they made in 2005–2006. These losses were still trickling into income statements in 2011, 2012, and even today.” The new standard will recognize losses on “an expected-loss basis” from inception. This is called the current expected credit loss model, or CECL. Cosper noted that the new model applies to all companies and financial instruments.

Uhl explained further: “It applies to all debt instruments that are amortized costs,” he said. “Loans held to maturity, debt securities, trade receivables, accounts receivable, also lease receivables. It also applies to some off–balance sheet commitments, those that are not insurance or derivatives—loan commitments, standby letters of credit, and financial guarantees.” Silva added that the model moves accountants “out of an awkward space. When you talk to business folks, they’ve never really understood the notion of an incurred loss approach. The basic premise of reflecting or disclosing the lifetime losses on your portfolio was an improvement.”

Strauss noted that the recording of other probable losses will still follow an incurred loss. Silva explained, “In the context of a financial asset that’s on your books, then the question is ultimately, ‘What am I going to recover?’ Because that’s probably the most useful information that you can provide.”

Cosper then continued by describing FASB’s planned guidance for the standard. “The board’s intent was to allow financial institutions to leverage their existing processes,” she said. “We made the guidance flexible in that way, talking specifically about the different kinds of models that [companies] use.” The guidance specifies that forecasts of expected loss should be “reasonable and supportable,” and that when those forecasts run out, adjusted historical loss information can be used.

In terms of the implications of CECL, LaMonte remarked, “What I’m really curious to see is how those day-one losses evolve as credit cycles evolve [i.e., from tight to loose standards]. It’ll be interesting to see if we do see larger dayone losses being recognized. That would really be telling us something.”

Elaborating further, Uhl said that “FASB decided to retain the model for available-for-sale debt securities, but made a couple of important changes.” Specifically, such securities will no longer be treated as other-than-temporary impairments, and impairments may be recognized as allowances rather than permanent write-downs of amortized cost. “When we had recoveries under the old model, they went through OCI,” Uhl explained. “Now we’ll recover that back in income.” He added that receivables purchased with a significant credit deterioration (i.e., SOP-03-3 receivables) will be recognized via an allowance. Finally, troubled debt restructurings will see some changes, although these are not yet finalized.

In terms of disclosure, LaMonte was particularly pleased with the vintage disclosures, saying they would “break down the loan book by year of origination. Having that breakdown is going to give us a lot of useful information.” Cosper noted, however, that nonpublic companies would be exempt from those disclosures, although the definition of “public” in this context is broad enough to include all but the smallest community banks.

Silva outlined the transition dates for the credit loss standard: 2020 for public companies, with the option to early adopt in 2019, and 2021 for nonpublic companies, with early adoption in 2020. The transition will be mostly via cumulative adjustment, but certain requirements, such as those for purchased financial assets with credit deterioration (PCD assets) and available-for-sale (AFS) securities previously impaired, will be prospective. The alternative, Silva said, “would have been recasting the accounting of these portfolios from the inception of time.”

Uhl then commented on other possible transition issues, saying that companies will have to consider how to obtain historical credit loss data, how far to extend forecasts, and how to transition from forecasts to historical data in forming their estimates. “I do have a lot of sympathy for those U.S. companies that may have foreign subsidiaries that have to do statutory IFRS [International Financial Reporting Standards] reporting or vice versa, because unfortunately the IASB’s model is significantly different,” he said.

Regarding conflicts with the international model, Cosper said that the IASB’s standard “didn’t meet the objective of what we were trying to accomplish. We had to listen to what our stakeholders needed.”

Derivatives and Hedging

Strauss turned the subject to the proposed derivatives and hedging standard. LaMonte called the complexity of the current standard “extraordinary” and “incredibly hard for financial statement users and investors to understand.” Uhl and Silva then summarized the proposal, laying out the five areas it intends to cover: 1) the overall hedge accounting model, which will allow effective qualitative testing after the initial quantitative test; 2) fair value hedges, which will no longer be split between effective and ineffective portions; 3) cash flow hedges, which will no longer be required to use the benchmark interest rate or overall cash flows; 4) partial-term hedging of interest rate risk, which will now be allowed; and 5) cash flow and net investment hedges, for which changes in fair value will be recorded in OCI and as part of the cumulative translation adjustment, respectively. Cosper noted that the exposure draft should be released this summer.

Prospects for Convergence

Strauss asked the panel to comment generally on the state of international convergence, which seems to him to be a low priority for standards setters. Cosper noted that while “having outcomes that are similar is a worthy goal,” often even identical language will be interpreted differently. An audience member followed this thread, asking about the potential fallout regarding the IASB’s own new credit loss standard. Silva replied that the thresholds used in the IASB model create a “cliff” beyond which credit losses would still be subject to the same paradox as before. Uhl agreed, but noted that FASB’s model has been criticized for potentially preventing banks from extending credit in an economic downturn. LaMonte noted that, especially in Europe, “loan losses have always been what the regulators want them to be.”

Norman Strauss, Ernst & Young’s executive professor in residence at Baruch College, moderated the panel.
Susan Cosper is the technical director at FASB.
Mark LaMonte is managing director at Moody’s Investors Service.
Kirk Silva is a vice president and accounting policy group head at the Federal National Mortgage Association (FNMA, or Fannie Mae).
Robert Uhl is a partner at Deloitte & Touche LLP.