More Change Coming for Treasury Accounting

By Joseph Neu

FASB’s proposed new accounting guidance on financial instruments is out for comment.

Months later than originally anticipated, on May 26, the FASB issued its long-awaited Exposure Draft (ED) for the current phase of its financial instruments project (conducted jointly with the IASB). The ED for this proposed Accounting Standards Update (ASU) indicates a big step closer to a total fair value approach to financial instruments accounting, including income recognition, but will still leave many balance sheets in limbo by not ushering in the full fair value era.

One way to look at the proposed guidance is that it takes all the fair value elements that had been relegated to the footnotes of financial statements and puts them on the face. Thus, to the extent you already mark everything you can to market, the proposed ASU would represent no big change. However, if you still prefer a historical/amortized cost approach you will be looking at substantial impacts. Just remember, you would still have the opportunity to keep presenting this information (and reconciling it to the fair value approach), but this information will be increasingly relegated to the footnotes of your financials.

Fair for the unfair?

Hardest hit will be banks where financial instruments are core to their business, but who so far have maintained significant portions of their balance sheets (including core loans and deposits) outside the fair value realm. Further changes toward fair value in the areas of measurement and income recognition, impairment, asset classifications and reclassifications will thus further contribute to the pro-cyclicality arguments of critics.

By forcing institutions to mark-to-market, accounting rules will exacerbate the impact of losses and declining valuations in bad times as well as inflate the gains and value increases when markets are good. No longer will banks have the luxury of building reserves in up-cycles to smooth out the loss impacts in down-cycles. Many critics also question the timing of pushing forward now, with so many banks still struggling to recover from losses exacerbated by fair value guidance introduced just prior to the financial crisis.

And it’s not just the banks that are seeing red. Non-financial corporates would, of course, also have to navigate the proposed rules and adjust accounting for financial instruments in their investment portfolios, used in hedging, and in funding. Plus, they will potentially have to pay more for bank products, including standby credit lines, that will have been made more costly by a requirement to carry them at fair value on top of regulatory capital rules.

To follow is a rundown of key items of concern to treasurers that might inspire a review of the proposed ASU, a comment letter prior to the September 30 deadline, or if you are really worked up, prompt you to arrange a field visit by the FASB staff to demonstrate the operational impact.

• Classification and measurement: By default, all financial instruments should be recognized at fair value with changes in fair value running through earnings. However, you have the option with a debt instrument, if you can make the case for a business strategy that calls for holding it until all the contracted cash flows are collected, to take a portion of the fair value change through OCI. Oh, and with your own debt, and with short-term payables/receivables, you can make the case for using amortized cost, but only if that matches your business strategy or the measurement mix of your current balance sheet.

There is also the OCI option available with hedges eligible for hedge accounting.

Also, related to measurement, be careful to assess the impact on receivables and payables: carrying them at amortized cost is ok if their terms don’t exceed a year, but if they are deemed loans (or credit card receivables) watch out.

Another important caveat to full fair value for banks is the measurement of core deposit liabilities. In a new approach, core demand deposits would “simply” be re-measured at each reporting period at the equivalent of the present value of the average core deposit amount, discounted at the difference between the alternative funds rate and the all-in-cost-of-service rate over the implied maturity of the deposits. These valuations could well result in deposits being carried at less than face value. Accordingly, some banks might prefer just to try and fair value all deposits.

• Impairment: The proposed ASU would replace current guidance for OTTI of debt securities as well as all financial assets currently accounted for at fair value in OCI. These would mostly see their credit impaired value, as measured against the discounted present value of the expected future cash flows when first booked, flow into earnings without any sort of impairment trigger. So, a probability or threshold of allowable decline no longer would be allowed.

Earnings gains or losses would then be subsequently recognized, as losses or reversals of prior losses, when changes in expected cash flows occur. Cash flow expectations should be based on all current information related to past events and current conditions, but not future events or conditions.

The trick, as with recently revised OTTI guidance would be isolating and measuring the credit impact on the cash flows. The lack of a probable threshold means that treasury investment managers will find it even more difficult to pick up yield by adding assets subject to credit risk in their portfolios without risking an EPS hit.

Earnings impacts may be exacerbated further thanks to the proposed guidance on interest income recognition for assets classified as held at fair value in OCI. For these, an entity would calculate interest income by applying the effective interest rate (EIR) based on the amortized cost balance, not fair value, and net of any related allowance for credit impairments. Thus, the determination of the EIR will fluctuate depending on whether a financial asset was purchased at a discount relative to its credit quality (not a great incentive for investors to pick up distressed assets).

• Hedge accounting: Borrowing from FAS 133(R), the proposed changes to hedge accounting are centered on replacing the “highly effective” standard for hedge accounting eligibility, which came to be defined as 80-125 percent, with “reasonably effective,” which the FASB will fight like mad to prevent from being defined in percentage terms.

Indeed, to reinforce the concept that hedge accounting eligibility should not be subject to a bright-line test, qualitative over quantitative effectiveness determinations are emphasized for determining hedge accounting eligibility.

Plus, and here’s a bit more good news, the need to hedge the full fair value of a hedged item, as proposed under the FAS 133(R), is gone. As under current guidance, hedgers could designate the benchmark interest rate and other sub-components of financial risk as what’s being hedged.

However, with this change comes the formal elimination of short-cut and critical terms match concepts of presumed effectiveness. And, ineffectiveness from both under- and over-hedging would show up in earnings, creating the potential for phantom earnings blips.

Also gone would be the ability to simply de-designate a hedge, forcing the termination of a hedge contract or purchase of an offsetting one to end a hedge accounting relationship.

A remaining sticking point in the new hedge accounting guidance is how it handles time value with option hedges (the G20 compromise). While time value can be deferred and amortized over the life of the option, unlike with the IASB approach, it is more unfriendly to options than the current FASB guidance, which allows for the entire fair value of the option to be made effective.

Important for exchange-traded, or standardized CCP-cleared derivatives, timing differences on hedge and hedged items, or for hedges of groups of transactions anticipated over a period, would be acceptable so long as they are reasonable. This means the difference must be minimal between the forward rate on that derivative used to hedge “and the forward rate on a derivative or derivatives that would exactly offset the changes in cash flows of the forecasted transactions.”

Finally, in reviewing the proposed ASU, keep in mind that the changes can seem simple in concept, as they are meant to be, but their implementation will be all but. Plus, as the ED also outlines, variances with IFRS 9, on the IASB side of the project would ultimately hamper convergence and any road map to global GAAP.