fasb financial instruments project - fms inc · • in this latest proposal, fasb has moved from...

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FASB Financial Instruments Project

June 18, 2013 2:00 – 3:15 pm

Presented by:

Jean Joy, CPA

Director of Financial

Institutions

Wolf & Company, P.C.

99 High Street

Boston, MA 02110

P: (617) 428-5432

E: [email protected]


Project Overview

May 2010 proposed Accounting Standards Update:

Accounting for Financial Instruments and Revisions to

the Accounting for Derivative Instruments and Hedging

Activities

• Global crisis highlighted gaps and inconsistencies in

current model

• Objective: single converged model that provides

useful, transparent, relevant information

• Fair value model for all financial instruments

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Project Overview

• December 20, 2012 – FASB issues proposed ASU,

Financial Instruments – Credit Losses (Subtopic 825-15)

– Comments due May 31, 2013

• February 14, 2013 – FASB issues proposed ASU,

Financial Instruments – Overall (Subtopic 825-10) –

Recognition and Measurement of Financial Assets and

Financial Liabilities

– Comments due May 15, 2013

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Project Overview

Project consists of three components:

1. Classification and Measurement

2. Impairment

3. Hedging

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Proposed ASU, Financial

Instruments – Overall (Subtopic

825-10) –

Recognition and Measurement of

Financial Assets and Financial

Liabilities

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Classification and Measurement -

General

• In this latest proposal, FASB has moved from its

original full FV proposal to a mixed measurement

model; amortized cost would be allowable for

financial assets that are held to collect cash flows.

• Changes will broadly converge the accounting for

debt investments and financial liabilities, but

significant differences in accounting for equity

investments will remain.

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Classification and Measurement -

Scope

• Noteworthy exclusions:

– Loan commitments and commercial LOCs (classify based

on underlying loan to be made, unless exercise is remote)

– Derivative instruments

– Others

• Depository and lending entities continue to follow

Topic 942 guidance on:

– FHLB and FRB stock

– NCUSIF deposits

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Classification of Financial Assets

• Upon recognition, financial assets will be classified

into the appropriate subsequent measurement

category.

• Initial measurement

Instruments that will be measured at FV through net income

will initially be recorded at FV. Transaction fees and costs

will not be deferred and will be recognized in net income at

inception of the transaction.

All other instruments will initially be recorded at their

transaction price.

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Measurement of Financial Assets

Subsequent measurement of financial assets is based on both of

the following:

1. Contractual cash flow characteristics of the asset

• Financial assets that do not pass the contractual cash

flow characteristics assessment are measured at FV-NI.

2. Business model for managing the asset

• The business model assessment leads to three

categories:

– Amortized cost (AC)

– Fair value through OCI (FV-OCI)

– Fair value through net income (FV-NI)

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Step 1 – Assessment of Contractual

Cash Flow Characteristics • Contractual cash flow characteristics are satisfied “if the

contractual terms give rise on specified dates to cash flows that

are solely payments of principal and interest on the principal

amount outstanding.”

• Financial assets not meeting the above characteristics must be

measured at FV-NI.

• Financial assets with elements of the following may not meet the

characteristics:

– Contingent cash flows

– Prepayment or extension options

– Timing and nature of interest rate resets

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Step 2 - Business Model Assessment

• Only applies to financial assets that pass the

contractual cash flows characteristics assessment

• Based on business activities for managing financial

assets

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Business Model Assessment - AC

• Assets qualifying for the AC category would be held

and managed within a business model that has the

objective of holding the assets to collect contractual

cash flows.

• Part of the management activities would focus on

managing credit risk to maximize the collection of

contractual cash flows.

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Sales of assets classified in the AC category:

• Sales based on deterioration of the issuer’s credit worthiness

would not be inconsistent with this classification if the

purpose is to maximize contractual cash flows.

• Sales for other reasons should be very infrequent. Sales that

result from events that are isolated, non-recurring, unusual

for the entity, and could not have been reasonably

anticipated are inconsistent with this classification.

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Sales of assets classified in the AC category

(concluded):

• Allowable reasons under SFAS 115 for selling HTM securities

would generally be consistent with this classification.

• When assessing a business model’s objective, consideration

should be given to pertinent historical experience, such as

historical sales and reasons therefore.

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Business Model Assessment – FV-OCI

• Assets held in the FV-OCI category will be managed within a

business model that has the objective of both:

a) Holding financial assets to collect contractual cash flows,

and

b) Selling financial assets to realize changes in fair values

(that is, at recognition, the entity has not yet determined

whether it will hold the individual asset to collect

contractual cash flows or sell the asset)

• The following activities are consistent with this classification:

• Managing exposure to interest rate risk

• Managing liquidity

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Business Model Assessment – FV-OCI

• The following will be recognized in net income:

– Current period income, including amortization of premiums,

discounts and deferred origination fees/costs

– Current period credit losses

– Change in FV attributable to hedged risk if the instrument is

the hedged item in a FV hedge

– Realized gains/losses on sale

– Foreign currency gains/losses

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Business Model Assessment – FV-NI

• This is the residual category; assets that fail the

business model assessment to qualify for AC or FV-OCI

are included in this category.

• Equity securities must be in this category, unless:

– The investment qualifies for the equity method of accounting

– The investment is consolidated in accordance with GAAP

– A practicability exception is elected (each reporting period) that

would allow certain equity investments without a readily

determinable fair value to be measured at cost with

adjustments for impairment and observable price changes that

meet certain conditions

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Reclassification of Financial Assets

• Reclassification is allowed only if the business model

within which the assets are held and managed

changes. This is expected to occur very infrequently.

• Reclassify as of the last day of the reporting period in

which the change occurs.

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• Generally recognized at amortized cost

• FV-NI required for:

– Short sales

– Financial liabilities for which the business strategy at

inception is to subsequently transact at FV

• If a non-recourse liability is required to be settled with

only cash flows from the related financial assets, the

accounting model would be based on that of the

related financial assets.

Classification and Measurement –

Liabilities

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Classification and Measurement –

Hybrid Instruments

• Hybrid financial assets would no longer be bifurcated

between the host contract and the embedded

derivative; the entire instrument would be assessed

for cash flow characteristics and business model.

• Hybrid financial liabilities will continue to be

bifurcated.

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Fair Value Option

• Would be limited to:

– Certain hybrid financial liabilities

– Groups of financial assets and liabilities that are managed

on a net exposure basis

– Financial assets otherwise eligible to be classified as FV –

OCI

– Hybrid non-financial liabilities under certain circumstances

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Presentation

• Assets and liabilities on face of balance sheet grouped

by measurement category

• AC category – public companies to disclose all FVs on

face of balance sheet, except for receivables/payables

due within one year and demand deposit liabilities

• FV – NI category – separate income statement line

item for aggregated realized and unrealized

gains/losses

• Other presentation issues

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Disclosure

• Applies to each interim and annual reporting period

• AC category – public companies to disclose significant FV

information (hierarchy, assumptions, changes, etc.)

• AC category – significant information concerning sales of

such financial assets

• Assets measured at FV-OCI – various disclosures

• Information relating to reclassifications

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Disclosure

• Core deposit liabilities – by significant type of core

deposit accounts: balance, implied weighted average

maturity and the estimated “all-in-cost-to-service rate”.

Disclosure required of public companies only.

• Nonrecourse financial liabilities

• Financial liabilities measured at FV under the FV Option

• Equity investments without readily determinable FVs

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Transition

• Adoption will result in a cumulative-effect adjustment

to beginning retained earnings.

• Early adoption is prohibited, with one limited

exception.

• Exception: An entity may early adopt the provision

that requires OCI presentation of the changes in fair

value due to changes in an entity’s own credit risk for

financial liabilities that are designated under the fair

value option.

• An effective date will be decided during final

deliberations.

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Proposed ASU, Financial

Instruments – Credit Losses

(Subtopic 825-15)

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Project Objective

– Provide financial statement users with more decision-useful

information about expected credit losses

– Reduce complexity by replacing the numerous existing

impairment models in current U.S. GAAP with a consistent

measurement approach

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Concerns with Current GAAP

• Delayed recognition of losses

– Probable threshold

– Incurred loss notion

– Limitations on ability to incorporate reasonable forward

looking information

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Scope

• Applies to all entities

• Applies to the following financial assets that are

subject to credit risk and are not classified at FV-NI:

– Loans

– Debt instruments

– Lease receivables

– Loan commitments

– Reinsurance recoverables

– Trade receivables

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Recognition

• An allowance will be recognized for current expected

credit losses (CECL): a current estimate of all

contractual cash flows not expected to be collected

• Practical expedient: For financial assets measured at

FV-OCI, an entity may elect not to recognize

expected credit losses if both of the following

conditions are met:

– The FV of the asset is greater than (or equal to) AC

– Expected credit losses are insignificant

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Estimation of Expected Credit Losses

• Based on internally and externally available

information, including:

– Information about past events, including historical loss

experience

– Current conditions

– Reasonable and supportable forecasts

– Quantitative and qualitative factors specific to borrowers and

the economic environment in which the entity operates

• Specific approaches or policy elections are not

mandated.

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Estimation of Expected Credit Losses

• The allowance must reflect the time value of money.

If using DCF model, the discount rate used is the

asset’s effective interest rate.

• Neither a worst-case or best-case scenario.

Consider at least two possible scenarios; one with a

credit loss and one without a credit loss.

• Reflects how credit enhancements (excluding

separate freestanding instruments) mitigate expected

losses

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Collateral-Dependent Financial Assets

• New definition expands “collateral-dependent” to

include financial assets for which repayment is

expected to be primarily or substantially through

operation (by the lender) or sale of the collateral

• Practical expedient allows for comparison of the FV

of the collateral to the AC basis to determine the

allowance for credit losses

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Purchased Credit Impaired Assets

• Accounting will change from current practice.

• ALL established at acquisition for buyer’s expected

credit losses.

• Portion of original discount related to credit losses will

not be recognized in income; remaining portion will

be recognized in interest income over the remaining

life using the effective yield method.

• Effective yield determined upon acquisition will

remain constant; changes in expected cash flows will

be recorded as gains/losses through the credit loss

provision.

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Interest Income

ASU only addresses interest income recognition related to

the following:

– PCI financial assets

– When to cease accrual

• When it is not probable that substantially all of the principal or substantially all

of the interest will be received

• If substantially all of the principal is not expected to be received, cash

receipts will reduce the carrying amount of the asset. When reduced to zero,

future amounts will be recognized as recoveries with any excess recognized

as interest income.

• If substantially all principal is expected, but it is not probable that substantially

all interest will be received, interest income will be recognized on a cash

basis when received.

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Write-offs

• Reduce the cost basis in the period in which it is

determined there is no reasonable expectation of

future recovery.

• Recoveries will be recorded as an adjustment to the

allowance only when consideration is received.

36


Presentation

• For assets measured at AC, an allowance for credit losses is

reflected on the balance sheet as a reduction of the AC of the

asset.

• For assets measured at FV-OCI, the estimate of expected credit

losses is a contra-asset that reduces the AC of the asset.

• For PCI assets not measured at FV-NI, the estimate of expected

credit losses is reflected as an allowance that reduces the sum

of the asset’s purchase price and the expected credit losses on

the asset at the time of acquisition.

• For loan commitments, the estimate of expected credit losses is

reflected as a liability.

37


Development of the Estimate

Assets evaluated individually:

– An entity may identify assets for individual evaluation; there

is no specific requirement to do so.

– Impairment is based on a present value technique using the

asset’s effective interest rate.

– Practical expedient for collateral-dependent assets

38


Development of the Estimate

• Examples provided in exposure draft

– Loss-rate approach

– Base component and credit risk adjustment

– By-vintage

– Collective estimate and individual estimate

– Provision matrix

All methods are judgmentally adjusted.

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Example Estimation Methods

Loss-rate approach

• Historical loss rate, updated for current conditions and

reasonable and supportable forecasts of future cash flows, is

applied to the amortized cost basis for applicable financial

assets.

Base component and credit risk adjustment

• In lieu of adjusting individual loss rates, develop base statistical

estimate of credit loss for financial assets with similar risk

characteristics and include credit risk adjustment to reflect

current conditions and reasonable and supportable forecasts of

future cash flows.

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By–Vintage

• Track losses on loans by year of origination. Patterns of credit

loss are developed and applied to assets by vintage. Make

adjustments for changes in current conditions as necessary.

Collective and Individual Estimation Methods

• Methods can be combined or changed over time. Example:

Loss-rate method is applied to performing loans in the segment

and discounted cash flow method, weighted for loss probability,

is applied to non-performing loans in the same segment.

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Provision Matrix

• Example: Loss-rate method by aging

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Factor Aging

0.3% Current

8% 1-30 days past due



75% 90+ days past due


Disclosures

• Significant disclosures:

– Credit-quality information

– Allowance for expected credit losses

– Roll forward for certain debt instruments

– Reconciliation between fair value and amortized cost for

FV-OCI

– Past-due status

– Nonaccrual status

– Purchased credit-impaired financial assets

– Collateralized financial assets

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Transition

• Effective date to be established when final

amendments are issued

• Proposed amendments to be applied by a

cumulative-effect adjustment

• Early adoption prohibited

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THANK YOU.

Questions?

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fasb financial instruments project - fms inc · • in this latest proposal, fasb has moved from...

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