Financial instruments

The FASB issued two of its three financial instruments standards so far in 2016: recognition and measurement and allowance for credit losses. An ED on hedging, the third piece of the original accounting for financial instruments project, was released in Q3 of 2016. Read PwC's latest thinking on financial instruments.

Changes to the current GAAP model primarily affect 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.

  • In January 2016, the FASB issued final guidance on the recognition and measurement of financial instruments.
  • The recognition and measurement project started as a joint project with the IASB, with an objective of improving the decision usefulness of financial statements by simplifying and harmonizing the accounting for financial instruments.
  • The new guidance will impact the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. The accounting for other financial instruments, such as loans, investments in debt securities, and financial liabilities not under the fair value option is largely unchanged.
  • The ASU makes significant changes to the accounting for equity investments. The ASU’s accounting model will apply to all types of equity investments, including equity instruments that meet the definition of a security (as provided under current US GAAP) and those that would not be considered securities (e.g., limited partnership interests).
  • Under the ASU, when the fair value option has been elected for financial liabilities, changes in fair value due to instrument-specific credit risk will be recognized separately in other comprehensive income (OCI).
  • The new guidance will be effective for PBEs 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 PBE effective date. For these entities, the guidance will be effective in fiscal years beginning after December 15, 2018 and interim periods within fiscal years beginning after December 15, 2019.

The guidance has a broad scope and requires that the CECL model generally apply to all financial assets measured at amortized cost and certain off-balance sheet exposures. The CECL model requires the recognition of an allowance, at the inception or acquisition of a financial asset, for the full amount of expected credit losses over the life of the financial asset. For available-for-sale debt securities measured at fair value with qualifying changes in fair value recognized in other comprehensive income, the ASU has a separate impairment model that is similar to the current guidance.

Given the scale of the change, some companies may require substantial time and effort to implement the new Standard. In addition, some companies may find that their systems and credit impairment models need to change. Companies may need to begin to collect and maintain additional data from internal and external sources for a period of time before adoption to have historical data to support expected loss calculations.

  • Following the financial crisis, the FASB was tasked with revisiting the accounting models for the impairment of financial assets. The FASB began the initiative working jointly with the IASB with the hopes of developing a converged standard. However, based on US constituent feedback, the FASB decided to adopt the current expected credit loss (“CECL”) model and therefore, the impairment models for financial assets under US GAAP and IFRS will not be converged.
  • The FASB issued a final accounting standards update ASU 2016-13: Financial Instruments – Credit Losses (the “ASU” or “Standard”) in June 2016.
  • The ASU has a broad scope and requires that the CECL model should generally apply to all financial assets measured at amortized cost and certain off-balance sheet exposures. The CECL model requires the recognition of an allowance, at the inception or acquisition of a financial asset, for the full amount of expected credit losses over the life of the financial asset.
  • For available-for-sale debt securities measured at fair value with qualifying changes in fair value recognized in other comprehensive income, the ASU has a separate impairment model that is similar to the current guidance. Some key changes to the current guidance include:

- 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 after the balance sheet date.
- A fair value floor will be incorporated into the credit loss fair value model for available-for-sale debt securities. Specifically, credit losses on available-for-sale debt securities will be limited to the difference between the security’s amortized cost basis and its fair value.

  • The ASU requires that the estimate of expected credit losses should not include forecasts of extension, renewals or modifications unless the company reasonably expects that such forecasts would be related to a troubled debt restructuring. Estimation of prepayments is required. 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 ASU includes the requirement to disclosure 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 ASU also expands 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. The five most recent years are required to be disclosed for public business entities that file with the SEC.
  • The ASU also includes a new guidance for assets purchased with evidence of more than insignificant credit deterioration since origination (“PCD assets”). The accounting for PCD assets require a day one allowance account to be established through a gross up to the balance sheet. Subsequent improvements in expected credit losses are recognized as a reversal to the previously established valuation allowance through earnings.
  • The ASU will be effective for public business entities that are SEC filers in fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. All other entities will have one additional year. Non-PBEs (including certain not-for-profit entities and employee benefit plans) are not required to adopt the guidance for interim periods until fiscal years beginning after December 15, 2021. Early application of the guidance will be permitted for all entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.
  • Given the scale of the change, some companies may require substantial time and effort to implement the new guidance. In addition, some companies may find that their systems and credit impairment models need to change.  Companies may need to begin to collect and maintain additional data from internal and external sources for a period of time before adoption to have historical data to support expected loss calculations.

On September 8, 2016, the FASB issued an ED to amend ASC 815 (Derivatives and Hedging).

The proposed guidance will impact hedge accounting for both financial and nonfinancial hedging relationships. The goals are to improve the alignment between hedge accounting and a reporting entity’s risk management objectives and to simplify hedge accounting for preparers. The proposed guidance, if finalized, will significantly change what qualifies for hedge accounting, how it is documented, how hedge effectiveness is assessed and hedge ineffectiveness is measured, and how the hedging results are presented and disclosed in the financial statements.

There are a number of changes proposed that will permit the application of hedge accounting to more hedge strategies. These proposed changes include:

  • Permitting the designation of contractually-specified components in cash flow hedges of forecasted purchases and sales of nonfinancial items. 
  • The benchmark interest rate concept in current US GAAP would no longer apply to variable rate instruments. For hedges of fixed-rate financial instruments, the designation of benchmark interest rates will continue, but the SIFMA Municipal Swap Rate will be added for tax-exempt issuers and investors.
  • The proposed guidance would also impact fair value hedges of interest rate risk. Reporting entities will be allowed to designate a portion of the term of a fixed-rate instrument as the hedged item, elect an alternative measurement methodology for the change in fair value of the hedged item, and may evaluate prepayment options differently in effectiveness tests.
  • All hedging relationships would still be required to be “highly effective” to qualify for hedge accounting. Companies would continue to perform initial quantitative effectiveness testing of all hedges, unless they meet the requirements for either the short-cut or critical terms match methods. However, the quantitative testing will no longer need to be performed contemporaneously. Subsequent quantitative effectiveness testing would not need to be performed unless a qualitative assessment indicates that the facts and circumstances in the hedging relationship have changed.
  • Reporting entities would not measure or record hedge ineffectiveness separately in each period; rather, the entire change in fair value of the hedging instrument would be recorded in the same income statement line item as the hedged item when it affects earnings. However, any amounts that are excluded from the assessment of the effectiveness of a cash flow hedge, such as changes in the spot-to-forward price difference, would be recognized in earnings immediately.
  • The proposal includes additional disclosures, including the cumulative basis adjustments for fair value hedges, the effect of hedging on individual income statement line items, and quantitative hedging goals.

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