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Financial Reporting and Regulatory Update

Third Quarter 2017

From the FASB

Final Standards

Hedge Accounting Overhaul

On Aug. 28, 2017, the FASB issued ASU No. 2017-12 “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” The update provides much-welcomed targeted improvements to simplify certain aspects of hedge documentation, effectiveness assessments, and accounting and disclosures, and it expands permissible hedge strategies. It also aligns financial reporting with an entity’s risk management activities and provides users with more decision-useful information about the effect of hedging activities. These are among the most significant changes:

Fair value hedges

  • Retains the concept of benchmark interest rates and expands it to include the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate for hedges of fixed-rate tax-exempt financial instruments
  • Permits companies to use the change in fair value of the hedged item using either the entire coupon or the portion of the contractual cash flows related to the benchmark interest rate, substantially reducing ineffectiveness in interest-rate hedges
  • Permits partial-term hedging (for example, hedging of first two years of 10-year instrument)
  • Introduces a new hedge method (“last-of-layer”), which allows for simplified hedging of pools of fixed-rate financial instruments (for example, mortgage loans)

Cash flow hedges

  • Replaces benchmark rate concept with contractually specified rate (for example, permits direct hedging of prime interest rate)
  • Permits designating the hedged risk of a forecasted purchase or sale of a nonfinancial asset to a contractually specified component within the hedged transaction (for example, if the settlement of a purchase or sale contract for brass was contractually tied to copper, permits the company to specify the copper component as the hedged risk)
  • Allows an assumption, under specific circumstances, that critical terms match in hedges of a group of forecasted transactions, which means that an entity can assume that the maturity dates of a derivative and the forecasted transaction are the same (that is, the terms match) if they occur within the same 31-day period or fiscal month

Both fair value and cash flow hedges

  • Permits certain hedges to use qualitative quarterly effectiveness assessments instead of quantitative assessments (for example, regression analysis), even if not 100 percent effective
  • Allows migration to long-haul method if shortcut method is determined to be inappropriate
  • No longer measures or recognizes ineffectiveness; if effective (80 to 125 percent), records hedges as if fully effective

Disclosure

  • Removes the ineffectiveness disclosure from the tabular footnote because it is no longer separately recorded
  • Adds tabular disclosure for cumulative-basis adjustments for fair value hedges to promote transparency of the last-of-layer method

Concurrent with the release of the ASU, the board also published a “FASB in Focus” article summarizing the new guidance.

Effective Dates

For PBEs, the update is effective for fiscal years beginning after Dec. 15, 2018, and interim periods within. For non-PBEs, it is effective for fiscal years beginning after Dec. 15, 2019, and interim periods beginning after Dec. 15, 2020.

Early adoption is permitted, including in any interim period after issuance of the ASU for financial statements that have not been issued or have not yet been made publicly available. If a company early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period.

Transition

Certain items must be applied using the modified retrospective method with an adjustment to opening retained earnings, while others may be applied only prospectively. Many items in the ASU may be electively applied to existing hedges (without dedesignating) also using the modified retrospective method, or they may be applied to new hedges prospectively.

The update also allows a one-time transfer of securities from held-to-maturity to available-for-sale, if they are eligible to be hedged under the last-of-layer method. Caution should be used when adopting as elections affecting existing hedges and security transfers are permitted only during adoption.

Resources

For more in-depth analysis, please read “FASB Just Moved a Mountain, Changed Landscape on Hedging,” issued by Crowe on Sept. 13, 2017.

Financial Instruments With Down Round Features Simplification

The FASB issued, on July 13, 2017, ASU 2017-11, “Earnings Per Share (Topic 260); Distinguishing Liabilities From Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments With Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests With a Scope Exception,” to address two separate issues.

Part I of the guidance addresses concerns with the complexity of accounting for certain financial instruments with down round features (for example, features that reduce the strike price of a financial instrument based on future equity offerings at a price less than the stated strike price). This ASU eliminates the requirement that an entity consider down round features when determining whether a financial instrument is indexed to its own stock under the liability or equity classification analysis, so that under the new guidance, an instrument with down round features will not be liability classified solely because of the down round features. Instead, for warrants and other freestanding equity classified financial instruments with down round features, companies that present earnings per share (EPS) will recognize the effect of a down round feature when it is triggered as a dividend and a reduction of income available to common shareholders in basic EPS.

Also, companies now will apply existing guidance for contingent beneficial conversion features (BCFs) to their convertible instruments with down round features (for example, debt or preferred stock convertible to common stock). Similar to warrants, down round features for convertible instruments (or BCFs) will be recorded only when the triggering event occurs, but unlike warrants, triggered BCFs will be recognized regardless of whether EPS is presented. BCFs are recorded as a discount to the convertible instrument with an offsetting credit to additional paid-in capital (APIC), and debt discounts are accreted to interest expense, while discounts to preferred stock are accreted to retained earnings and reported as a deemed dividend.

The ASU also requires disclosure of the conversion and exercise price change features (such as down round features) for equity-classified instruments. In the period that the down round feature is triggered, companies are required to disclose that fact and the value of the effect of the feature that has been triggered.

Part II of the ASU addresses the 2003 effective date deferral of FASB Statement 150, “Accounting for Certain Financial Instruments With Characteristics of Both Liabilities and Equity,” for mandatorily redeemable financial instruments of certain nonpublic entities and certain mandatorily redeemable noncontrolling interests, which is memorialized in Accounting Standards Codification (ASC) 480- 10-65-1. Some find that content in the codification difficult to read and to navigate, so the board replaced the indefinite deferral with a scope exception. As such, there is no accounting impact.

Effective Dates

Part I provisions related to down round features are effective for PBEs for fiscal years beginning after Dec. 15, 2018, and interim periods within. For all other entities, Part I provisions are effective for fiscal years beginning after Dec. 15, 2019, and interim periods within fiscal years beginning after Dec. 15, 2020. Early adoption is permitted for all entities, including in an interim period.

Proposals

Recognition and Measurement Clarifications

On Sept. 27, 2017, the FASB issued an exposure draft that contains two proposals for technical corrections and improvements to two recent accounting standards, one of which is a proposal for recognition and measurement: “Two Proposed Accounting Standards Updates – Technical Corrections and Improvements to Recently Issued Standards: I. Accounting Standards Update No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities and II. Accounting Standards Update No. 2016-02, Leases (Topic 842).”

The board is proposing the following six clarifications to ASU 2016-01:

Equity securities without a readily determinable fair value

  • Equity securities without a readily determinable fair value
    • The measurement alternative in ASC 321-10-35-2 applies until the investment has a readily determinable fair value or becomes eligible for the net asset value practical expedient. The proposal would clarify that an entity may also change from the measurement alternative to a fair value method consistent with Topic 820, “Fair Value Measurement”, for all securities of the same type.
    • When an observable transaction occurs for a similar security, ASC 321-10-55-9 requires that adjustments made should reflect the current fair value of the security, and the proposal would clarify that those adjustments should be made as of the date that the observable transaction took place.
    • Forward contracts and purchased options on equity securities for which the measurement alternative is expected to be applied are accounted for on a look-through basis in accordance with ASC 815-10-35-6. The proposal would clarify that remeasurement of the entire value is required when an observable transaction on the underlying equity investment occurs.
    • A prospective transition approach is required for all equity securities without a readily determinable fair value, and the proposal would clarify that approach is only required when the measurement alternative is applied.
  • Fair value option (FVO) financial liabilities
    • Presentation of financial liabilities for which the FVO has been elected is required, and the proposal would further clarify that the presentation guidance in ASC 825-10-45-5 should be applied whether the FVO was elected under ASC 825-10 or ASC 815-15 for embedded derivatives.
    • The fair value change attributable to instrument-specific credit risk for FVO financial liabilities is required (ASC 825-10-45-5) to be separately presented in other comprehensive income. The proposal would clarify, for FVO financial liabilities measured in a foreign currency, that the change in fair value related to instrument-specific credit risk should be presented separately from other changes in fair value in the liability’s currency of denomination. Then, the instrument-specific credit risk component of the fair value change should be adjusted to reflect the current exchange rate, consistent with ASC 830-20-35-2, and the remeasurement of the instrument-specific credit risk component should be presented in accumulated other comprehensive income.

Comments are due Nov. 13, 2017.

Lease Accounting Clarifications

The exposure draft issued on Sept. 27, 2017, also addresses the recent lease accounting standard: “Two Proposed Accounting Standards Updates – Technical Corrections and Improvements to Recently Issued Standards: I. Accounting Standards Update No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities and II. Accounting Standards Update No. 2016-02, Leases (Topic 842).”

The board is proposing 16 clarifications to ASU 2016-02 on the following topics:

  • Residual value guarantees
  • Rate implicit in the lease
  • Lessee reassessment of lease classification
  • Lessor reassessment of lease term and purchase option
  • Variable lease payments that depend on an index or a rate
  • Investment tax credits
  • Lease term and purchase option
  • Transition guidance for:
    • Amounts previously recognized in business combinations
    • Certain transition adjustments
    • Leases previously classified as capital leases under Topic 840
    • Modifications to leases previously classified as direct financing or sales-type under Topic 840
    • Sale and leasebacks
  • Impairment of net investment in the lease
  • Unguaranteed residual asset
  • Effect of initial direct costs on the rate implicit in the lease
  • Failed sale and leaseback transactions

Comments are due Nov. 13, 2017.

Practical Expedient for Land Easements

The FASB issued, on Sept. 25, 2017, a proposal, “Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842,” to address the costs of applying the new lease accounting guidance to land easements (that is, a “right to use, access, or cross another entity’s land for a specified purpose,” often referred to as a “right of way”). Currently, in accounting for land easements, some entities apply Topic 840 for leases, and others apply guidance such as Topic 360 for property, plant, and equipment.

Under the proposal, all entities would apply the new lease accounting guidance in Topic 842 to land easements. However, a practical expedient in transition would allow entities that do not currently apply Topic 840 to existing land easements to continue to apply current accounting policies to all land easements that existed or expired before the effective date of Topic 842. Subsequent to adoption of the new lease guidance, Topic 842 would be applied prospectively to all new or modified land easements.

The effective dates and transition would be the same as those for ASU 2016-02, “Leases (Topic 842).”

Comments are due Oct. 25, 2017.

Rearrangement of Consolidation Guidance

On Sept. 20, 2017, the FASB issued a proposal, “Consolidation (Topic 812): Reorganization,” to reorganize its consolidation guidance contained in ASC Topic 810 in a manner that is consistent with the order in which the guidance should be applied. The proposal would move the guidance from Topic 810 to a new section, Topic 812, and add two subtopics – one for variable interest entities (VIEs) and one for voting interest entities.

The board does not expect the proposed reorganization to change current practice.

Comments are due Dec. 4, 2017.

Revenue Recognition of Grants and Contracts by Not-for-Profit Entities

On Aug. 3, 2017, the FASB issued a proposed ASU, “Not-for-Profit Entities (Topic 958): Clarifying the Scope and the Accounting Guidance for Contributions Received and Contributions Made,” to address diversity in practice on how contributions are characterized and accounted for by not-for-profit entities. It proposes a framework for determining whether certain transactions (such as grants) are exchanges or contributions, which is an important distinction because the accounting treatment differs.

In an exchange transaction, the resource provider receives commensurate value in exchange for resources transferred, and entities would apply Topic 606 (“Revenue From Contracts With Customers”) or other applicable guidance. In a contribution, on the other hand, each party does not receive and sacrifice commensurate value. The proposed guidance may result in more grants and contracts being accounted for as contributions than under current practice.

For a contribution, the proposal provides guidance on determining whether the contribution is conditional or unconditional by clarifying a donor-imposed condition versus a donor-imposed restriction. Determining whether a contribution is conditional or unconditional is important because it affects the timing of revenue recognition.

The proposal primarily would affect not-for-profit entities because a major source of income for those entities is contributions, and it would be applicable for both receiving and providing contributions. But the guidance would not be limited to not-for-profit entities; it would apply to any entity that receives or makes contributions of cash or other assets. However, it would not apply to transfers of assets from the government to business entities.

If adopted, the standard would be effective consistent with the revenue recognition guidance in Topic 606:

  • For PBEs and not-for-profit entities that have issued, or are conduit bond obligors for securities that are traded, listed, or quoted on an exchange or an over-the-counter market, the standard would be effective in annual periods beginning after Dec. 15, 2017, including interim periods within.
  • For all other entities, it would be effective in annual periods beginning after Dec. 15, 2018, and interim periods within annual periods beginning after Dec. 15, 2019.
  • Early adoption would be permitted for all entities.

Concurrent with the proposal, the board released a “FASB in Focus” article that provides background information on why the board is addressing the issue and how the proposal would improve accounting for contributions by not-for-profit entities.

Comments are due Nov. 1, 2017.

Other Projects on Our Watch List

Troubled Debt Restructurings in Credit Losses Standard

On Sept. 6, 2017, the FASB discussed unresolved issues for troubled debt restructurings (TDRs). The issues, previously debated at the June 12, 2017, meeting of the Credit Losses Transition Resource Group (TRG), related to when an allowance estimate for TDRs should be recognized and the complexities of measuring certain TDR concessions (such as interest-rate and term concessions) using a method other than a discounted cash flow (DCF) method.

At the FASB meeting (memorialized in Memo 6A on the TRG Meetings page), the board clarified that it did not intend to change the identification method for TDRs; as such, identification of a TDR is required when an individual asset is specifically identified as a reasonably expected TDR. In addition, the board concluded that once specifically identified, a TDR must be measured using a DCF method (or a method that reconciles to a DCF model) when an entity grants a concession that can be measured only using a DCF model (such as an interest-rate or term concession). The FASB said it did not intend to allow measurement of TDRs in a way that avoids capturing TDR concessions.

Furthermore, if an entity uses a DCF method for measurement of credit losses on a performing loan portfolio, adjustments for TDRs that are incremental to what is embedded in the historical loss information should not be incorporated as an input to the model until a TDR is individually identified.