Financial instruments

The FASB issued its much awaited final standard on classification and measurement in January 2016. Changes to the current GAAP model primarily affects the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. In addition, the FASB clarified guidance related to the valuation allowance assessment when recognizing deferred tax assets resulting from unrealized losses on available-for-sale debt securities. The accounting for other financial instruments, such as loans, investments in debt securities, and financial liabilities is largely unchanged.

The classification and measurement guidance is the first ASU issued under the FASB’s financial instruments project. The ASU for the new impairment guidance is expected in the first quarter of 2016. An exposure draft of the new hedging guidance is expected in the first half of 2016.

  • On January 5, 2016, the FASB issued a final standard for classification and measurement (Accounting Standards Update 2016-01).
  • Equity investments (not accounted for under the equity method) will be measured at fair value, with changes in fair value recognized in net income. However, entities other than investment companies and broker-dealers will be afforded a practical expedient for investments that do not have readily determinable fair values. Under this practical expedient, such investments would be measured at cost less impairment and adjusted for observable price changes. An impairment adjustment to its fair value would be triggered by a qualitative assessment of impairment indicators.
  • The accounting for debt investments (i.e., loans and debt securities) will remain largely unchanged subject to the new proposed impairment model.
  • If the fair value option is elected for a financial liability, adjustments to the value due to changes in an entity’s own credit risk will be recorded in other comprehensive income.
  • In keeping with the FASB’s simplification project, the board modified the disclosure requirements for non-public business entities, which will now be exempt from disclosing the fair value of financial instruments at amortized cost. The board also eliminated the requirement for public business entities to disclose the methods and significant assumptions used to estimate the fair value of financial instruments measured at amortized cost for disclosure purposes.
  • Financial assets and financial liabilities will be required to be presented separately, grouped by measurement category and class of financial asset in the statement of financial position or in the accompanying notes to the financial statements.
  • The IASB issued its final guidance on targeted amendments to its classification and measurement standard in July 2014. The IASB’s classification and measurement standard is substantially the same as the prior FASB model that was proposed in the ASU issued in February 2013.
  • The classification and measurement guidance will be effective for public business entities in fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. All other entities, including certain not-for-profit entities and employee benefit plans, will have an additional year, or may early adopt coincident with the public business entity effective date.
  • All entities can early adopt the provision to record fair value changes for financial liabilities under the fair value option resulting from instrument-specific credit risk in other comprehensive income. Entities that are not public business entities can early adopt the provision permitting the omission of fair value disclosures for financial instruments at amortized cost. Early adoption of these provisions can be elected for all financial statements of fiscal years and interim periods that have not yet been issued (for public business entities) or that have not yet been made available for issuance. 
  • In 2012, the FASB and IASB moved in different directions in their approaches to developing a new impairment model for financial assets.
  • The IASB's approach would classify debt investments into categories that reflect the pattern of credit deterioration over time. Those categories would dictate the model for determining the amount and timing of when credit losses would be recognized in earnings. All assets would initially be recognized in the first category, where a credit loss would be recorded based on the probability of a default in the next twelve months. Once an asset experiences a significant deterioration in credit risk, it would move to a second category, at which point an allowance would be recorded for the full lifetime expected credit losses.
  • The FASB opted for a model that would require recognition of an allowance, at the inception or acquisition of a financial asset, for the full amount of credit losses over the life of the financial asset. The FASB issued an exposure draft on its model, referred to as the current expected credit loss (CECL) model, in December 2012.
  • With respect to the FASB model, feedback was mixed. Users generally supported the FASB model, as they preferred a model that would require recognition of all credit losses (as opposed to only ‘some’ expected credit losses). Preparers, on the other hand, did not support the FASB’s proposed model, struggling to reconcile the recognition of credit losses at the inception of a lending arrangement with the credit assessment inherent in the pricing of the transaction. Instead, preparers preferred a model that would recognize those losses expected to occur in the ‘foreseeable future’ or some other truncated period.
  • Throughout the fall of 2013, the FASB conducted outreach with both preparers and users, and conducted joint discussions with the IASB. Ultimately, after considering several alternatives, the FASB decided in December 2013 to move forward with the CECL model and refine various aspects, where necessary. That decision eliminates the possibility of convergence between the FASB and IASB in the recognition and measurement of credit losses.
  • Following its decision to move forward with the CECL approach, the FASB has continued to refine that model. The board subsequently decided that the CECL model should generally apply to all financial assets measured at amortized cost. For debt securities measured at fair value with qualifying changes in fair value recognized in other comprehensive income, the board decided that use of an impairment model similar to that in current guidance would be appropriate, with the following proposed changes.

–     An allowance approach would be used to recognize credit related impairment losses, which would allow an entity to recognize reversals of credit losses to the extent improvements occur.

–     Removal of the requirement to consider the length of time that the fair value of an available for sale debt security has been less than its amortized cost when estimating whether a credit loss exists.

–     Removal of the requirement to consider recoveries or additional declines in fair value of an available for sale debt security.

–     A fair value floor will be incorporated into the credit loss fair value model for AFS debt securities. Specifically, credit losses on AFS debt securities will be limited to the difference between the security’s amortized cost basis and its fair value.

  • The FASB concluded that contractual cash flows, as defined in the proposed standard, would not include forecasts of extension, renewals or modifications unless the entity expects that such forecasts would be related to a troubled debt restructuring. Estimation of prepayments would be allowable under the standard. It was reaffirmed that expected credit losses for unfunded loan commitments should reflect the full contractual period over which the entity is exposed to credit risk, unless unconditionally cancellable by the issuer. 
  • The FASB has concluded that disclosure requirements will include a rollforward schedule of the allowance for credit losses for all in-scope financial assets, including available for sale debt securities. This disclosure requirement is similar to what is required in current GAAP for receivables.
  • The board has also tentatively concluded that companies will not be required to disclose a rollforward schedule of amortized cost as tentatively proposed in prior deliberations. Instead, the proposed disclosure will expand the current US GAAP requirement for disclosure of credit quality indicators for receivables to all financial assets within scope, excluding available for sale debt securities and reinsurance receivables. The disclosure will require presentation of the amortized cost balance for each class of financial asset by credit quality indicator, disaggregated by year, vintage, or origination. A minimum of two years comparative disclosures will be required, with up to five years permitted.
  • The board affirmed that assets purchased with evidence of more than insignificant credit deterioration since origination would be classified as purchase credit deteriorated (PCD). The accounting for PCD assets would require a day one allowance account to be established through a gross up to the balance sheet. Today’s model requires deteriorations in expectations of cash flows to be recorded as impairments through a valuation allowance. Improvements in expected cash flows are recognized as a reversal to a previously established valuation allowance. If there is no valuation allowance, improvements in expected cash flows are recognized prospectively as effective yield adjustments. The setup of a day one allowance account in the proposed model would allow for improvements in expected cash flows to be recognized immediately through reversal of the allowance with a credit to earnings. 
  • At its November 2015 meeting, the FASB voted for an effective date for public business entities that are SEC filers for annual and interim periods beginning after December 15, 2018. Public business entities that are not SEC filers would be required to adopt the standard for periods beginning after December 15, 2019. The standard would be effective for all other entities for periods beginning after December 15, 2020.
  • The FASB’s decisions on the classification and measurement of debt investments represent a major change from its proposed model and are a significant setback to achieving global convergence in this area.
  • Many believe that financial instruments accounting is overly complex and sometimes results in inconsistent information being reported for economically similar instruments.
  • Some stakeholders believe that the financial crisis highlighted the need for potential improvements in how and when impairment losses are recognized on loans, investments in debt, and related securities. Both boards' models attempt to respond to these constituent concerns, albeit in different ways.

Completion of the standard is pending finalization of transition guidance and implementation examples, and deliberation on any further feedback received during the staff’s outreach. The final impairment standard is expected to be issued in the first quarter of 2016.


Listen to our podcast for an overview of derivatives and hedging: the fundamentals

Need a refresher on derivatives and hedge accounting? Listen in to get grounded in the fundamentals.

Financial asset impairment: Overview of the FASB’s new guidance webcast - July 25, 2016

07/25/16

During this webcast we will discuss various aspects of the new standard, including the current expected credit loss model (CECL), and new guidance on debt investments, purchased credit-impaired assets, troubled debt restructurings, and beneficial interests.

In depth: The FASB’s new financial instruments impairment model

07/11/16

On June 16, the FASB issued new impairment guidance for financial instruments that will impact all reporting entities.

Podcast: Derivatives and hedging: the fundamentals

06/29/16

Need a refresher on derivatives and hedge accounting? Listen in to get grounded in the fundamentals.

The quarter close: Directors edition Q2 2016

06/20/16

This quarterly publication is designed to keep directors informed about the latest accounting and financial reporting issues.

Structured payables

06/20/16

Entering into a structured payable transaction may be more than you bargained for; changing your payable to debt classification.

In brief: Allowance for loan and lease losses – FASB issues final impairment standard

06/16/16

On June 16, the FASB issued new impairment guidance for financial instruments that will impact all reporting entities.

Guide to Accounting for Transfers and Servicing of Financial Assets - 2013 second edition (March 2016)

05/31/16

PwC is pleased to offer the 2013 edition of our popular publication, Guide to Accounting for Transfers and Servicing of Financial Assets.

New guidance on recognition and measurement of financial instruments

05/20/16

Insights on the FASB’s recently issued guidance on recognition and measurement of financial instruments, including a review of key changes and implementation considerations for impacted companies.

Accounting Standards Update 2016-05, Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships

04/28/16

This issue of financial markets insights explores novations and why they happen, what is changing under ASU 2016-05, and next steps for businesses.

Financial instruments, an overview of the recognition and measurement standard

04/25/16

Watch this overview of the new FASB standard on the recognition and measurement of financial instruments.