Summary of current accounting events impacting financial institutions
As you approach year-end, it's a good time to review various accounting standards finalized over the last couple of years that may affect your 2012 reporting period. Additionally, there are a number of proposed standards and major projects underway that could significantly impact financial institutions. The following provides a summary of each.
Select recently effective accounting standards
Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. In July 2010, the Financial Accounting Standards Board (FASB or Board) released Accounting Standards Update (ASU) No. 2010-20, "Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses." This ASU put forth extensive new disclosure requirements, some of which result in more disaggregated presentation of pre-existing requirements by portfolio segment and class of financing receivable. While the disclosures came in to effect during 2010 and 2011 for public entities, they did not come in to effect for nonpublic entities until annual reporting periods ending on or after Dec. 15, 2011. Accordingly, all nonpublic entities with a fiscal year-end of Dec. 31, 2011 would have already implemented this guidance, while nonpublic entities with a Sept. 30, 2012 fiscal year-end are just recently implementing this guidance. While comparative disclosures were encouraged but not required for earlier reporting periods that ended before initial adoption, comparative disclosures are required for those reporting periods ending after initial adoption. Refer to our article entitled Disclosures about credit quality of financing receivables and allowance for credit losses for additional information and suggestions for complying with these requirements.
Troubled debt restructurings. In April 2011, the FASB released ASU No. 2011-02, "A Creditor's Determination of Whether a Restructuring Is a Troubled Debt Restructuring," to address perceived inconsistencies in application of the pre-existing guidance. This guidance became effective in 2011 for public entities and for annual periods ending on or after Dec. 15, 2012, including interim periods within those annual periods, for nonpublic entities. The ASU retained the guidance that for a troubled debt restructuring to have occurred, both of the following must exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. Key provisions of the ASU include the following:
- If a debtor does not otherwise have access to funds at a market rate for debt with similar risk characteristics as the restructured debt, the restructuring would be considered to be at a below-market rate, which may indicate that the creditor has granted a concession. In that circumstance, a creditor should consider all aspects of the restructuring in determining whether it has granted a concession.
- A temporary or permanent increase in the contractual interest rate as a result of a restructuring does not preclude the restructuring from being considered a concession because the new contractual interest rate on the restructured debt could still be below the market interest rate for new debt with similar risk characteristics.
- A restructuring that results in a delay in payment that is insignificant is not a concession. The ASU includes examples illustrating the assessment of whether a delay in payment is insignificant.
- A creditor may conclude that a debtor is experiencing financial difficulties, even though the debtor is not currently in payment default. A creditor should evaluate whether it is probable that the debtor would be in payment default on any of its debt in the foreseeable future without the modification.
- A creditor is precluded from using the effective interest rate test in the debtor's guidance on restructuring of payables (ASC paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a troubled debt restructuring.
Repurchase agreements. In April 2011, the FASB issued ASU No. 2011-03, Reconsideration of Effective Control for Repurchase Agreements, with the objective of improving the accounting for repurchase agreements and similar transactions. The ASU modifies the assessment of effective control for the purpose of determining if a sale should be recognized by eliminating the criterion related to the transferor's ability to repurchase or redeem financial assets on substantially the agreed terms, even in the event of default by the transferee, under the belief that this is not a determining factor of effective control. The ASU also eliminated the related requirement to demonstrate that the transferor possesses adequate collateral to fund substantially all the cost of purchasing replacement financial assets.
The ASU is effective for the first interim or annual period beginning on or after Dec. 15, 2011 and should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date.
Fair value measurements and disclosures. In May 2011, the FASB released ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU required prospective application for interim and annual periods beginning after Dec. 15, 2011 for public entities and for annual periods beginning after Dec. 15, 2011 for nonpublic entities. In addition to putting forth additional fair value disclosure requirements, the ASU amended the wording used to describe certain requirements for measuring fair value to promote consistency with International Financial Reporting Standards (IFRS).
Presentation of Comprehensive Income. In June 2011, the FASB released ASU 2011-05, "Presentation of Comprehensive Income," to improve the comparability and consistency associated with how comprehensive income is reported as well as to increase the prominence of items reported in other comprehensive income. This was in part accomplished by eliminating the option to present components of other comprehensive income as part of the statement of changes in stockholders' equity. The components must now be presented, either in a single continuous statement of comprehensive income or in two separate but consecutive statements consisting of a statement of net income followed by a statement of other comprehensive income. The ASU requires retrospective application and is effective for fiscal years, and interim periods within those years, beginning after Dec. 15, 2011 for public entities and for fiscal years ending after Dec. 15, 2012, and interim and annual periods thereafter for nonpublic entities. The ASU also required presentation of reclassification adjustments on the face of the financial statements. This requirement was deferred through the issuance of ASU No. 2011-12 in December 2011, while the Board reconsidered this requirement, which culminated in the issuance of a proposed ASU in August 2012. The proposed ASU would require enhanced disclosures of the impact of reclassifications out of accumulated other comprehensive income in a footnote disclosure rather than on the face of the financial statements. A final standard is expected to be issued in the first half of 2013.
Testing Goodwill for Impairment. In September 2011, the FASB released ASU No. 2011-08, "Testing Goodwill for Impairment," in response to concerns about the cost and complexity of performing the goodwill impairment tests required under ASC No. 350. This ASU provides an option for an entity to qualitatively assess whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount before proceeding with a determination of the fair value of the reporting unit. If it is not more likely than not that the fair value is less than the carrying amount, it is not necessary for the entity to perform the two step impairment test outlined in ASC No. 350-20 for that reporting unit. An entity can choose this option for some periods but not others. The ASU includes examples of events and circumstances that an entity should consider in evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The ASU was effective for annual and interim goodwill impairment tests performed for fiscal years beginning after Dec. 15, 2011, with early adoption permitted. For additional information, refer to our article entitled FASB issues final standard on qualitative goodwill impairment assessment.
Disclosures about Offsetting Assets and Liabilities. In December 2011, the FASB released ASU No. 2011-11, "Disclosures about Offsetting Assets and Liabilities," to help facilitate comparison between those entities that prepare their financial statements on the basis of U.S. GAAP and those entities that prepare their financial statements on the basis of IFRS. The ASU requires disclosure of both gross and net balances for instruments and transactions that are eligible for offset as well as transactions subject to an agreement similar to a master netting arrangement. The scope includes derivatives, sale and repurchase agreements and reverse sale and repurchase agreements, and securities borrowing and lending arrangements, as well as other financial instruments that are either (1) offset in accordance with either ASC Section 210-20-45 or ASC Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement. Application is required for annual reporting periods beginning on or after Jan. 1, 2013, and interim periods within those annual periods. Retrospective disclosures are required for all comparative periods presented.
Testing Indefinite-Lived Intangible Assets for Impairment. In July 2012, the FASB released ASU No. 2012-02, "Testing Indefinite-Lived Intangible Assets for Impairment." Similar to ASU No. 2011-08 discussed above, this ASU was issued to reduce the cost and complexity of performing an impairment test for indefinite-lived intangible assets by providing an option for an entity to assess qualitatively whether it is not more likely than not that the asset is impaired before proceeding with an annual determination of fair value. The ASU is effective for annual and interim impairment tests performed for fiscal years beginning after Sept. 15, 2012, with early adoption permitted. For more information, refer to our article on this topic entitled Qualitative impairment assessment of indefinite-lived intangible assets.
Indemnification assets. In October 2012, the FASB issued ASU No. 2012-06, "Subsequent Accounting for an Indemnification Asset Recognized at the Acquisition Date as a Result of a Government-Assisted Acquisition of a Financial Institution," to address diversity in practice on how these types of indemnification assets are subsequently measured. This ASU clarifies that when a change in the cash flows expected to be collected from such an indemnification, asset occurs as a result of a change in cash flows expected to be collected on the assets, subject to indemnification (such as acquired loans subject to an FDIC loss sharing agreement), the reporting entity should subsequently account for the change in the measurement of the indemnification asset on the same basis as the change in the assets subject to indemnification. Any amortization of changes in value should be limited to the lesser of the term of the indemnification agreement and the remaining life of the indemnified assets. This could be relevant, for example in the context of acquired loans with credit quality issues accounted for in accordance with ASC 310-30-35, which requires certain post-acquisition improvements in expected cash flows to be accreted in to income over the remaining life of the loan. Similarly, an associated decrease in the indemnification asset would be amortized, with the amortization period being limited to the lesser of the term of the indemnification agreement and the remaining life of the indemnified loans. The ASU is effective for fiscal years, and interim periods within those years, beginning on or after Dec. 15, 2012, with early adoption permitted. It requires prospective application to any new indemnification assets acquired after the date of adoption and to indemnification assets existing as of the date of adoption arising from a government-assisted acquisition of a financial institution.
Select proposed accounting standards
Disclosures about Liquidity and Interest Rate Risk. In June 2012, the FASB issued a proposed ASU entitled "Disclosures about Liquidity Risk and Interest Rate Risk," with the goal of providing users of financial statements with more decision-useful information about an entity's exposure to liquidity risk and interest rate risk. The proposed requirements are extensive and somewhat duplicative of information public entities are required to include in periodic filings with the Securities and Exchange Commission. The comment period on this proposed ASU ended Sept. 25, 2012, with many constituents expressing concerns. As such, the Board has more work to do before releasing a final standard.
Major joint projects. While it is not always smooth sailing, efforts continue and progress has been made in certain respects as it relates to the joint major projects of the FASB and IASB. Refer to our summary entitled FASB and IASB convergence projects at-a-glance for an update on the four major projects (Leases, Financial Instruments, Revenue Recognition and Consolidation). Financial institutions will likely be one of the industries most impacted by the Financial Instruments project. Additionally, the leases project is of interest to financial institutions that engage in a significant amount of leasing activity as a lessor or lessee. Based on decisions made to date, the Revenue Recognition project would also have an impact on financial institutions, in particular by replacing the existing guidance for accounting for sales of foreclosed properties. As it pertains to the Financial Instruments project, exposure documents are expected to be released by or near year-end for classification and measurement as well as credit impairment. Based on tentative decisions made thus far, the following represent some of the most significant changes to existing guidance for financial institutions:
- Marketable equity securities would be measured at fair value, with changes in fair value reflected through the income statement.
- Financial assets other than equity securities (debt securities and loans receivable) would be accounted for based on cash flow characteristics and business strategy as follows:
- Instruments with contractual cash flows that do not consist solely of principal and interest as well as instruments that do not meet the business strategy criteria to be carried at amortized cost or fair value through other comprehensive income (OCI) or loss would be carried at fair value through net income.
- If contractual cash flows are limited to principal and interest, financial assets would be carried at amortized cost if the business strategy is to hold the assets for the collection of contractual cash flows, or at fair value through OCI if the business strategy is both to hold the instrument to collect the contractual cash flows and to sell the instrument.
- Reclassifications of financial assets would occur only if the business model changes, which should be infrequent.
- A fair value option would be limited to certain hybrid financial liabilities and certain groups of financial assets and liabilities that are managed on a net exposure basis.
- Changes in the fair value of liabilities accounted for under a fair value option pertaining to a change in the reporting entity's own credit risk would be presented separately in OCI.
Significant efforts by both the FASB and IASB have been put forth to date to attempt to develop a converged approach for accounting for credit impairment of debt financial assets. During the summer, the FASB decided to move away from the three-bucket credit impairment model that was under joint development with the IASB due to concerns expressed by U.S. constituents about the understandability, operability and auditability of this model. The FASB has since been separately focused on the development of a new model referred to as the "Current Expected Credit Loss Model" (CECL Model). Based on board decisions made to date, under the CECL Model, the credit impairment allowance at each reporting date would reflect an entity's current estimate of the expected credit losses on its financial assets. Expected credit losses are defined as the estimate of contractual cash flows not expected to be collected and would generally be developed by giving consideration to probability of default expectations, loss rates upon default, and discounting of expected cash flows. Recognizing impairment based on expected credit losses rather than probable losses under current guidance for the allowance for credit losses is intended to address the perception that losses were recognized too late at the start of the recent credit crisis. Credit deterioration or improvement reflected in the income statement for a given period would include changes in the estimate of expected credit losses resulting from, but not limited to, changes in the credit risk of assets held by the entity, changes in historical loss experience for assets like those held at the reporting date, changes in conditions since the previous reporting date, and changes in reasonable and supportable forecasts about the future.
The FASB indicated that they expect that credit loss estimates will often be measured for pools of similar asset types based on internally-assigned credit risk ratings. Similar to existing practice, an entity could develop its estimate of expected losses by beginning with its historical loss experience for a particular risk rating category and then adjusting the historical loss experience for current conditions, and reasonable and supportable forecasts about the future. Consistent with the Board's previous decision on the three-bucket impairment model, the Board decided that an entity's estimate of expected credit losses should reflect the time value of money using the financial asset's effective interest rate to discount cash flows. The Board indicated that because the amortized cost basis of a financial asset represents the principal and interest cash flows discounted at the original effective interest rate, measurement approaches that estimate expected credit losses based on historical charge-off rates are acceptable methods of reflecting the time value of money. Similarly, the Board decided that as a practical expedient, measurement approaches for collateral-dependent financial assets that estimate expected credit losses by comparing the cost basis with the fair value of collateral are acceptable methods of estimating expected credit losses in a manner that reflects the time value of money.
Consistent with current accounting requirements, interest income would generally be recognized on the basis of contractual cash flows. An exception to this general rule would exist for purchased financial assets that have experienced significant deterioration in credit quality since origination as the discount embedded in the purchase price attributable to expected credit losses (non-accretable yield) would not be included in interest income. In all other regards, such purchased assets would follow the same approach described above such that the allowance for originated financial assets and purchased credit impaired financial assets would be measured consistently. Separate balance sheet and income statement presentation would be required though to distinguish amounts pertaining to purchased assets with significant credit quality deterioration. Interest accruals would be ceased on all assets when it is not probable that full payment of principal or interest will occur. In those circumstances, interest income would be recognized on a cash basis unless full payment of principal is not probable, in which case a cost recovery method would be employed.
The application of the proposed model to debt instruments measured at fair value with changes reported in OCI and debt securities will likely be the subject of future discussions that could affect the tentative decisions made to date.
For more information, please contact Faye Miller, director, at 410.246.9194.