On January 5, 2016, the FASB issued ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, to address certain aspects of recognition, measurement, presentation and disclosure of financial instruments that are marked to fair value and reported as available-for-sale (“AFS”). As this standard is effective for calendar year SEC registrants beginning in 2018, companies have time now to prepare their transition planning as this ASU will impact a variety of complex areas. CFGI is working with clients and encouraging companies to plan and prepare with key stakeholders in order to plan for and implement the standard. 

WHAT TO EXPECT?
This ASU requires an entity to: (i) measure equity investments (other than those consolidated or accounted for under the equity method) at fair value through net income; (ii) present in other comprehensive income (“OCI”) the changes in instrument-specific credit risk for financial liabilities measured using the fair value option; (iii) present financial assets and financial liabilities by measurement category and form of financial asset; (iv) calculate the fair value of financial instruments for disclosure purposes based on an exit price and; (v) assess a valuation allowance on deferred tax assets related to unrealized losses of AFS debt securities in combination with other deferred tax assets.

With the adoption of this ASU we can expect the following:

• Increase in income statement volatility, as changes in the fair value of equity investments will flow through earnings • New required disclosures for instrument specific credit risk, and how it impacts the value of the equity investment
• The practicability exception requires new disclosures around the fair value of equity investments • Changes in an entity’s credit risk will no longer affect earnings
• Provide fair value information about financial instruments carried at amortized cost including the level of the fair value measurement hierarchy (level 1, 2 or 3) • For public entities, use of the exit price notion when measuring the fair value of all financial instruments for disclosure purposes, instead of the entry price notion
• Elimination of the requirement to disclose the method(s) and significant assumptions used to estimate fair value for financial instruments measured at amortized cost for public entities • Accounting for securities classified as trading and other financial instruments will remain largely unchanged

PREPARING FOR CHANGE

Financial Assets

  • Current GAAP requires financial instruments to be classified as either held to maturity, trading or AFS, unless the investments are accounted for under the equity method of accounting. Held to maturity securities are carried at amortized cost. Changes in the fair value of trading securities are recognized through earnings while the investment is held. Any changes in the fair value of AFS securities are recorded in equity within OCI, and recognized when the investments are sold or the liability is settled.
  • The ASU requires changes in the fair value of financial instruments to flow through earnings, and eliminates the recording of gains and losses in OCI, with a few exceptions under the measurement alternative.
    • If fair value is not readily determinable a measurement alternative should be followed:
      • Requires the investment to be carried at cost less impairment, if any, and plus or minus subsequent adjustments for observable price changes.
      • Impairments are considered based on a qualitative assessment of indicators that include, but are not limited to: earnings performance, environmental factors, market conditions, bona fide offers to purchase or sell, or going concern issues.
      • Observable price changes are based on orderly transactions for the identical or a similar investment from the same issuer.
    • If the entity qualifies for the practical expedient to estimate fair value under ASC 820-10-35-59, net asset value per share or equivalent may be used.
  • For equity securities without readily determinable fair values, entities must now disclose the carrying amount of investments, and the periodic and cumulative impact of any impairments including subsequent adjustments, and additional narrative form information to help users understand the disclosure.

Financial Liabilities

  • For financial liabilities accounted for under the fair value option, the portion of the fair value change related to instrument-specific credit risk will be recorded separately in OCI. This is a significant change from GAAP, which currently requires the entire fair value change to be recognized through earnings.
  • This ASU does not apply to derivative liabilities.
  • If the liability is settled before maturity, any gains or losses accumulated in OCI will be recognized in earnings.

Deferred Tax Assets

  • Changes in the fair value of AFS financial instruments do not change the tax basis of the investment and create temporary differences, giving rise to a deferred tax asset (“DTA”) or deferred tax liability.
  • The ASU clarifies that the assessment of DTAs related AFS debt securities should be made in combination with all other DTAs as opposed to the entity having the option to assess DTAs on an individual basis.

Presentation of Financial Assets and Liabilities
This ASU requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or in the notes to the financial statements.

Disclosures for Financial Instruments Measured at Amortized Cost

  • Public entities – are required to measure the fair value of a financial asset or financial liability using the exit price concept as noted in Topic 820 when disclosing fair value of financial instruments measured at amortized cost. This change to existing GAAP eliminates the entry price method previously used by some entities for disclosure purposes on some financial instruments. Public business entities will no longer have to disclose the method and significant assumptions used in estimating those fair values.
  • Non-public entities – eliminates the requirement under Topic 825 – Financial Instruments, to disclose the fair values of financial assets and financial liabilities measured in the financial statements at amortized cost.

EFFECTIVE DATES

  • The new guidance requires a modified retrospective approach to adoption.
  • Entities will make a cumulative-effect adjustment to beginning retained earnings as of the beginning of the first year of adoption and successive change in fair value of equity securities without readily determinable fair values will be prospectively accounted for in the income statement.

Public Filers

  • The Update is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2017.
  • Early adoption is permitted for the provision related to instrument-specific credit risk.

Non-public Filers

  • The Update is effective for fiscal years beginning after December 15, 2018 and interim periods after December 15, 2019.
  • Early adoption is permitted for the elimination of fair value disclosures for financial instruments not recognized at fair value.

NEXT STEPS
We encourage companies to begin the evaluation process to determine the impact of this ASU on their organizations. CFGI can assist clients with assessing information needs, updating documentation, performing assessments and communicating potential changes to management, auditors and other stakeholders. Let our experience assisting clients across a variety of industries help your company in its adoption of the new guidance. Please contact us for more information.