Accounting for Financial Instruments: New Requirements

The Financial Accounting Standards Board (FASB) has made a significant change to accounting standards related to accounting for financial instruments. Accounting Standards Update 2016-01 (ASU 2016-01), Financial Instruments, was issued in January 2016, with the most significant change affecting accounting for equity securities. Adjustments to fair value of some equity securities will be adjusted through the income statement and will no longer be adjusted through other comprehensive income (OCI). As a result, the fair value adjustments will no longer be a component of accumulated OCI in the equity section on the balance sheet. With the implementation deadline quickly approaching, entities must familiarize themselves with the new requirements, how the guidance will affect their financial statements, and how to meet regulatory requirements.

Effective Date

ASU 2016-01 became effective for public entities on their first fiscal year that began after December 15, 2017. Non-public entities were given an additional year to comply. For non-public entities, annual reports must reflect the new standard for fiscal years that begin after December 15, 2018, and interim period reporting within fiscal years that begin after December 15, 2019.

Provisions of ASU 2016-01

This update has several changes that will impact financial reporting for financial institutions. Previously, equity securities were carried on the balance sheet based on their classification as held to maturity, available for sale, or trading. Adjustments to fair value of these securities were recorded through OCI or the income statement based on the classification, or they could be carried at cost if their fair values were not readily determinable. Going forward, applicable equity securities will be recorded at fair value with the resulting fair value adjustments recorded through the income statement. Investments in Federal Home Loan Bank (FHLB) and Federal Reserve Bank (FRB) and some options and hedging instruments are excluded from the scope of this update. The changes resulting from ASU 2016-01 could potentially have a significant impact on net income and regulatory calculations for financial institutions.

For equity investments that do not have a readily available fair value, entities can elect to reflect them at cost as long as they:

• Adjust for impairment. Impairment may be indicated, for example, if there is a deteriorated credit rating, an adverse change in the regulatory environment, or for going concern.

• Adjust for an observable price change of an identical or similar investment from the same issuer.

In other words, entities must now effectively estimate the fair value of their investments if the true fair value is unknown. Management will need to employ new policies that help determine these estimates.

This accounting standards update made a few other changes, as well.

Deferred Tax

Prior guidance allowed for book/tax differences in available-for-sale securities to be excluded from the valuation allowance calculation associated with deferred tax assets. ASU 2016-01 now requires the entity to consider these differences in combination with their other deferred tax assets before determining the appropriate valuation allowance.

Recognition of Credit Risk

Changes to fair value that can be traced to instrument-specific credit risk are recorded through OCI rather than the income statement, as was previously required. This adjustment will eventually cycle through net income once the liability has been settled.

Disclosures

Most accounting standards that have been released in recent years have expanded disclosure requirements, and ASU 2016-01 is no exception. Going forward, financial assets must be presented by type of instrument (e.g., loan, debt security, equity security) and by how value is determined (e.g., fair value through net income, fair value through OCI, amortized cost), either in the footnotes or on the face of the financial statements. Other required disclosures include, among othes:

• Disaggregated realized from unrealized gains and losses resulting from equity investment fair value adjustments on the income statement
• Carrying amount for equity securities whose fair values cannot be readily determined
• Explaining how estimated fair values have been determined and what assumptions were made
• Demonstrating the fair value change that is attributable to instrument-specific credit risk
• Clarifying why amounts relating to credit risk settlements remain in OCI rather than being recorded through the income statement (if relevant)

The update does eliminate the requirement for non-public business entities to disclose the fair value of financial instruments that are not measured at fair value on a recurring basis. For public entities, the update eliminates some disclosure details regarding assumptions used to estimate fair value of financial instruments measured at amortized cost.

Transition

To transition to ASU 2016-01, entities must report a cumulative-effect adjustment to their balance sheet at the beginning of the first reporting period in the year of adoption. This means that calendar year non-public entities must record an adjustment effective January 1, 2019.

The time to implement new policies and procedures to comply with ASU 2016-01 is upon us. If you need help getting started, a member of LaPorte’s Financial Services Industry Group can help guide you. While we cannot determine a financial instrument’s fair value for you, we can assist with your strategies for implementation. Contact Jaclyn Broussard or any of our Financial Services Industry Group members for assistance.