Financial instruments

Financial instruments are pervasive across all reporting entities and even more so in the financial services sector.

The FASB is revisiting the accounting for financial instruments. The FASB issued two of its three financial instruments standards: recognition and measurement and allowance for credit losses. An ED on hedging, the third part of the original accounting for financial instruments project, was released in September, 2016.

Recognition and measurement

  • Current guidance on recognition and measurement of financial assets and liabilities is primarily included in ASC 320, Debt and Equity Securities.
  • In January 2016, the FASB issued updated guidance on the recognition and measurement of financial instruments, which amends ASC 320 for new guidance on debt securities and creates a new subtopic, ASC 321, Equity Securities. The recognition and measurement ASU also amended some other subtopics, including ASC 825.
  • The new 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 new guidance, 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 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 new guidance will be effective for public business entities (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.
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Allowance for credit losses (Impairment of financial assets)

  • The FASB issued final guidance on impairment of financial assets in June 2016. ASU 2016-13, Credit Losses, provides a new impairment model for both financial assets measured at amortized cost and available-for-sale equity securities.
  • The current expected credit loss (CECL) model generally applies 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 changes in fair value recognized in other comprehensive income, the ASU has a separate impairment model that is similar to current guidance.
  • The ASU also includes 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 (PBEs) 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 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.
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Derivatives and hedging

Current guidance on derivatives and hedging is primarily included in ASC 815, Derivatives and Hedging

In September, 2016, the FASB issued a proposal to amend 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.

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.
  • 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. 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.
  • 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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