Financial Instruments

About the Panelists

Robert Uhl, partner at Deloitte & Touche LLP; Scott Taub, managing director at Financial Reporting Advisors LLC; Mark LaMonte, former managing director at Moody’s Investors Service; Kirk Silva, vice president and head of accounting policy at Fannie Mae; and Jay Shah, project manager at FASB, were the panelists. Norman Strauss, distinguished lecturer of accountancy at Baruch College, moderated the panel. The following is an edited and condensed summary of the panel discussion. The views expressed are the panelists’ own personal views and not necessarily those of their employers or those employers’ boards, management, or staff.

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Strauss opened the panel by asking Mark LaMonte whether users are happy with the state of reporting for financial instruments. “I don’t know as anyone’s happy with the way this is going,” LaMonte replied, noting that 11 years have passed since FASB and the IASB took on the revision accounting standards for credit losses in the wake of the 2008 financial crisis. “U.S. GAAP and IFRS have come up with very divergent solutions here,” he said, “and the U.S. GAAP solution is rather unique in that the day you make a loan, you will be putting a reserve on your balance sheet for that loan. Banks in particular are going to see their loan loss reserves jumping pretty dramatically.” LaMonte also said that he has seen “some decent quantification” in on SAB 74 CECL (current expected credit loss) disclosures, which he characterized as “some pretty material effects in terms of the loan loss reserves. How it flows through to the effect on capital isn’t nearly as significant, but the balance sheets of these banks will be looking somewhat different.”

Kirk Silva then tried to explain this change. “The new standard says, based on everything you know today, your historical experience, and your projections about what’s to come, what’s your best estimate of the losses you’re going to incur over the life of these portfolios?” Silva added, “This isn’t really just a financial services standard; we expect that it will apply broadly to many companies.” Robert Uhl pointed out that the standard also applies to contract assets, which people often miss.

Implications of the Expected Loss Model

Scott Taub added that the required measure of a loan was less than both fair value and cost, which he found “remarkable. Usually, we choose between cost or fair value; here we’ve said, no to both.” He continued by providing an example: “Make a million-dollar loan, the risk-free rate is 5%. You perceive that there’s a 3% chance that you’re not going to get paid, so you might be making a little profit. You charge 9% on the loan, you take an immediate 3% loss. You are going to record a reserve based on the expected losses, not taking into account the fact that you’re charging interest on that loan.” Strauss clarified that this recording takes place on day one, to which Taub noted, “There’s no question that this is understood and this was intended. I just find it very difficult to explain to my clients.”

Shah then responded to a query from Strauss about FASB’s internal take on this requirement. “This expected credit loss model is built on the incurred loss model,” Shah said. “You start off with historical loss assumption, and you’re just going to be considering a reasonable supportable forecast and then reverting back to your historical loss information.” Taub replied that while this analysis works on a portfolio level, “it fails when you look at it loan by loan.”

Taub also acknowledged that the prior incurred loss model had its own issues, saying, “It was always very difficult to identify whether a loss has been incurred. The positive thing about CECL [current expected credit losses] model is you no longer have to figure that out; you incurred the loss when you made the loan, as it turned out … that does remove a point of judgment that was something of a fool’s errand. … But what we’ve got is going to be complicated as well.” Explaining further, he said that while banks may have internal processes that mirror this model, commercial companies might have no experience with the approach at all, although the change for them may turn out to be immaterial.

Continuing, Strauss asked whether commercial companies with 90-day trade receipt rules could ignore future analyses entirely. Taub said that, while the change for such a company would not be large, “it’s at least something that you need to monitor. And more importantly, for commercial companies that have debt portfolios or that sometimes make loans to other companies in their industry as a form of investment, CECL applies; they’ll have to do the work.” Strauss also asked whether commercial companies will need documentation showing they know about the new rule; Uhl clarified that they will.

Silva then discussed how the model would apply to long-term loans, such as 30-year mortgages. “It’s even more complicated,” he said, “because those loans are prepayable, and so it’s not really a 30-year period that you’re going to lose over; it might be a five- to seven-year period for a fixed-rate, 30-year mortgage.” Continuing, he noted that, while lenders can generally expect some percentage of their long-term loans to eventually default, the actual amount is dependent upon changing economic factors. Both Silva and Taub confirmed that the allowance for credit losses would likely increase under the new rule.

Strauss then asked whether this rule would have helped during the last financial crisis. Silva opined that banks would have built their reserves faster due to incorporating the forecast of falling home prices into their planning. LaMonte added that, as banks began to make poorer loans in the years leading up to the crisis, their recognition of higher expected losses might have provided a clue to that fact. Uhl’s view was that any certainty about the effects of the rule in such a situation would have to wait until the next financial downturn; he also noted that the IASB’s divergent standard would be similarly tested, leading to an opportunity for comparison.

FASB Guidance on CECL

Jay Shah discussed FASB’s efforts at providing guidance for the new credit losses standard. Shah began by stressing that FASB went through “a rigorous process” when developing the standard, exploring many alternative models before arriving at the one they used based on feedback from stakeholders. “The standard itself is intentionally built to be scalable; it should be adoptable by all entities, big and small,” he continued. “I think you’re supposed to build on what you were doing and you just should look at your historical loss information, which you’re doing today, presumably. … There’s a lot of judgment there. We keep reminding everyone just go look at the guidance, it’s flexible intentionally.” Shah also explained that the duration of inputs can vary, and that companies are not required to search for all possible information when making estimates. “It’s a best-estimate model, similar to what insurance companies do for long-duration contracts,” he said.

Strauss asked how auditable the information produced under the new rule would be. “I think that the auditors will encounter the same difficulties the preparers do,” Uhl replied. Uhl also discussed two exceptions to the new rule: available-for-sale debt securities and purchased financial assets that have experienced credit deterioration (PCD). Available-for-sale debt securities, he said, are already listed at fair value on the balance sheet if they are likely to be sold; for securities that do not meet that criterion, he said, will have a valuation allowance with a floor at fair value. PCDs will have their allowance added back to their basis to arrive at amortized cost.

Asked about modified disclosures, LaMonte said that some of the new disclosures will be very useful. “‘Vintage’ disclosures will be extraordinarily useful to users in understanding what the profile of loans made in any given year looks like and how that is evolving as credit cycles evolve,” he said. “Things go wrong when the credit quality deteriorates or the underwriting standards deteriorate; I think these vintage disclosures will help provide some indication of when that’s happening.”

Taub then ran down the effective dates and transition periods; the effective date will be January 1, 2020, for public companies and January 1, 2021, for other entities. While early adoption is allowed, Taub said he had not heard of any companies actually taking advantage of that option. As to transition, he noted that “the big banks are starting to give some numbers as to what the effects are, so you can tell that they are making progress on analyzing what’s going to happen.” Taub also predicted that FASB will go forward with allowing entities to use fair value estimates for existing loans at transition. Strauss noted that Accounting Standards Update (ASU) 2019-04 contains various amendments for several topics related to CECL; Taub and Shah explained that the amendments are intended to clarify issues raised during the Transition Resource Group (TRG) process.

Next, Silva discussed implementation issues encountered by banks and other financial institutions so far. Finding the necessary data has been a big issue, Silva explained. “Even if you have credit loss data, you may not have used that data for financial reporting,” he said. “There’s generally a lot of cleanup associated with pulling that data out of the business and then using it in a financial reporting capacity.”

On the subject of the requirement for “reasonable and supportable forecasts,” Silva noted that most organizations are utilizing external forecasts for this purpose and pointed out that adjusting historical data to reflect the forecasted information will require significant judgments from management. Shah added that FASB has received questions about what method to use for those adjustments and reminded the audience that the guidance is designed for flexibility. “If you think straight line is appropriate, use straight line; just explain why you’re using straight line,” Shah said.

Derivatives and Hedging

With CECL fully covered, Strauss turned the panel toward recent changes to accounting for derivatives and hedging. Asked to explain the goals of ASU 2017-12, Shah said the standard attempted to expand hedging into more risk management activities. “Now you can hedge components of your financial and nonfinancial risk,” he explained, “rather than the entire purchase price or the entire contract and all the cash flows that come with it.” The standard also simplifies the hedge effectiveness assessment. Strauss and Shah agreed that the standard has been well received by stakeholders.

Next, Uhl discussed the general complexity of hedge accounting, both before and after the new standard. “As the sophistication of risk management strategies goes up, the complexity in the accounting obviously goes up,” Uhl said. “While FASB has accomplished a lot in making this easier, there are things that you’re still going to have to go through in order to accomplish hedge accounting.” As an example, he talked about documentation, which for the most part must still be done in the same amount of time, and “that’s going to require you do some complex math.”

Silva discussed his implementation experience with a client. “Although the changes reduce the amount of modeling that’s necessary to support the ultimate outcome,” he said, “there’s still significant operational challenges associated with putting this in place. It isn’t easy if you’ve got significant volume that you want to hedge, but it is modeling-light, and that was the significant benefit.” Taub agreed, saying that no longer having to measure ineffectiveness every period was another big improvement. “In just about every area of hedge accounting,” Taub said, “FASB made it a little easier. Cumulatively, it’s a substantive difference.” He tells clients, “You may find that the accounting is not as scary as it used to be.”

Continuing with the technical discussion, Silva explained how the testing for whether or not a hedge is “highly effective” has changed. The amount of time for the initial test has increased, and while that test must still be quantitative, subsequent tests can be qualitative as long as the issuer provides documentation that it still considers the hedge highly effective. “You may end up spending more time on the back end with your audit firm, trying to defend your qualitative assessment,” Silva said, “but if you have less volume than we’re talking about and you’re not putting something in place that’s automated,” the process will be easier overall.

Uhl had a mixed view on how smoothly implementation of the standard has gone. While the improvements mentioned above have been well received, Uhl described the transition as “a little bit bumpy,” saying that FASB is working on some technical corrections to address questions that have come up regarding, among other things, partial term hedging and hedging components of nonfinancial assets. LaMonte added that, while financial statement users have not particularly focused on this standard, it will still be useful to the extent that it removes unnecessary volatility it will result in a better economic presentation. “It’s more of a perspective issue than a catch-up issue,” LaMonte said.

Classification and Measurement of Financial Instruments

Strauss then moved the discussion on to FASB’s project on the classification and measurement of financial instruments, ASU 2016-01, effective in 2018 for public companies and 2019 for private companies. Taub explained that the standard targeted three specific areas: measurement of equity investments, presentation of changes in fair value of a company’s own debt, and certain fair value disclosures for non-public companies. At Strauss’s request, Shah clarified elements of the target areas that did not change, such as classification of debt securities. He also said that FASB has received requests to extend the fair value option to some held-to-maturity debt securities.

Silva then commented on the changes to equity investments, delineating them from equity method investments, which are unaffected, and noting exceptions to the new rule, such as consolidated equity investments and cases where fair value is not readily determinable. Uhl further explained the mark-to-market method of the new rule, stressing the new, qualitative requirements for determining impairment, which he described as a “much easier model than what we had previously.”

Uhl then discussed practice issues, noting that FASB had plans to discuss issues that had been brought to its attention regarding purchase or sale of equity securities that would move an issuer across the threshold between using the equity method or the measurement alternative. Taub added that removing the other-than-temporary impairment test was “a big simplification.”

LaMonte said that the standard should result in more intuitive results, noting a particular feature of the old rule that resulted in increased decreased credit-worthiness generating income. Companies, he said, would frequently resort to non-GAAP measurements to avoid this apparent paradox, so this change will lead to a decrease in use of non-GAAP. He also said that companies have reacted positively to the fair value option for changes in their own debt.

Strauss asked how the standard affects convergence with international standards. Silva said that while the models are different, the end result is “very similar.” Taub added that the standards were already substantially converged prior to the new standard, and that the changes might actually create divergence.

Taub then summarized the effective dates, noting that the transition for public companies for the most part went smoothly, although some companies with investments in equity securities that chose the measurement alternative and had been using the cost method previously ended up recognizing large amounts of built-up appreciation.

Final Thoughts

The panel wrapped with Strauss asking the panelists for their thoughts on future developments for financial instruments. Uhl noted that the projects on distinguishing liabilities and equity and on hedging will continue, while Taub said that “there will continue to be financial instrument accounting issues because we keep inventing new financial instruments.” Shah praised the efforts of the TRG for the credit losses standard, saying, “I think we got through a number of simplifications and clarifications for the CECL standard in a short time period.” He added that FASB is always available to take questions and concerns about existing standards or other matters that need addressing.