Sometime late this year, the Financial Accounting Standards Board will reveal its cards. That is, FASB will reveal more details about how companies — particularly financial institutions — should value their financial assets and liabilities at fair value. A FASB proposal that is out for public comments aims to include loans in that category, and that is likely to spark the ire of bankers and their lobbyists. Here’s a brief summary of the situation, so far.
Currently, accounting rules say that with respect to financial institutions, only debt and equity securities are required to be reported at fair value. The mandate is spelled out in the rule known as FAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” In practice, that means the unrealized gain or loss associated with the securities is reported in “other comprehensive income.”
However, under another FASB rule, known as FAS No. 159 (“The Fair Value Option for Financial Assets and Liabilities”), entities are permitted to elect to measure “eligible items” at fair value. In this case, the entity must report unrealized gains and losses on items for which the fair-value option has been elected in earnings.
For purposes of FAS No. 159, financial assets that a company chooses to measure at fair value include cash, evidence of an ownership interest in an entity, or a contract that conveys to one entity a right to receive cash or another financial instrument from a second entity. A financial liability, in turn, includes a contract that imposes on one entity an obligation to deliver cash or another financial instrument to a second entity. As a result, the principal financial assets to which FAS No. 159 applies are loans and other receivables.
The provisions of FAS No. 159 are uncharacteristically flexible. What’s more, all entities may elect the fair-value option for a recognized financial asset and liability, as long as the item is not an interest in a subsidiary or a variable-interest entity (VIE) that the entity is required to consolidate, or deposit liabilities of banks, savings and loan associations, credit unions, or similar depository institutions that can be withdrawn on demand.
In addition, the fair-value option may be elected for a single eligible item without electing it for other identical items. Further, fair-value accounting need not be applied to all items issued or acquired in a single transaction. To be sure, most financial institutions have selectively applied the fair-value option, and very few such institutions have chosen to subject their loans to this option. FASB, however, seems to be moving down a path toward requiring the reporting of loans at fair value.
Witness the proposal the board floated in July, entitled “Accounting for Financial Instruments,” which seems to be gathering momentum.1 The proposal envisions that all financial instruments, including loans, will be presented on the balance sheet at fair value. Also, any changes in value will be recognized in net income or other comprehensive income, with an optional exception for “own debt,” which will be measured at amortized cost.
For example, losses due to “credit impairment” would be recognized in net income, whereas losses attributable to all other factors would be reflected in other comprehensive income. So for the purposes of the FASB proposal, the board will be adopting the principles it employs in bifurcating “other than temporary impairment” (OTTI) charges between net income and other comprehensive income. In addition, recycling of realized gains and losses upon liquidation of an instrument — from other comprehensive income into net income — will be required.
It is likely that FASB will move deliberately in implementing this proposal. In fact, we do not expect to see a draft embodying the details of the proposal until late in the fourth quarter. Once the document is issued, FASB will request commentary on its provisions from all interested parties.
Depending on the tenor of the commentary, FASB may feel the need to “reexpose” the document before finalizing it. Accordingly, we would expect the earliest the proposal will become effective is for years beginning after December 15, 2010.
The banking industry will no doubt be opposed to this dramatic expansion of the “mark to market” rules, and will argue that the need to mark loans to market, and record the unrealized gains or losses in earnings, will cause undue earnings volatility. In any event, it should be interesting to see whether FASB can successfully implement something that should be vehemently opposed by those entities the proposal most directly affects.
Robert Willens, founder and principal of
Robert Willens LLC
, writes a weekly tax column for CFO.com. This extra column was written to update readers on the closely-watched fair-value accounting debate.
1 The FASB project entitled “Accounting for Financial Instruments” was formerly called “Financial Instruments: Improvements to Recognition and Measurement.”