CUNA Regulatory Comment Call

June 15, 2010

Exposure Draft: Accounting for Financial Instruments

EXECUTIVE SUMMARY

Objective

The Financial Accounting Standards Board’s (FASB’s) objective in developing this proposal is to provide financial statement users with a more timely and representative depiction of a reporting entity’s involvement in financial instruments, while at the same time reducing the complexity in accounting for those instruments. Currently, there is a high threshold for recognition of credit impairments that the Board believes to impede timely recognition of losses.

In addition, the proposal is intended to increase uniformity by eliminating the current option for an entity to use different accounting treatments for similar financial instruments. For example, under existing U.S. generally accepted accounting principles (GAAP), debt instruments may be measured at: (1) amortized cost (such as loans held for investment or held-to-maturity debt securities); (2) the lower of cost or fair value (such as loans held for sale); or (3) fair value (such as trading securities).

Overview of Proposed Changes

The proposal would apply to all entities that have financial instruments. This includes all credit unions with assets greater than $10 million, which the Federal Credit Union Act requires to follow GAAP. The extent of the impact on an entity would depend on the relative significance of financial instruments in the entity’s operations, financial position, and business strategy.

The proposal addresses the accounting treatment of most financial assets and liabilities, including:

Only a few types of financial instruments would be exempt from the guidance, such as, pension obligations and leases.

The Board considered whether the proposed guidance should apply only to entities of a certain size or industry, or only to public companies, but decided that all entities that transact in financial instruments should be required to apply this comprehensive accounting model. Thus, the Board believes that all entities with similar financial instruments should account for those instruments in a similar manner.

Under the proposal, the specific accounting treatment for a financial instrument would depend on the characteristics of the instrument and the way it is used in the entity’s business.

As proposed, most financial instruments held for collection or payment of cash flows would need to be reported at both amortized cost and fair value on the balance sheet. In addition, amortized cost and fair value information would need to be used in determining net and comprehensive income. Changes arising from interest accruals, credit impairments, and realized gains and losses would be recognized in net income.

With the exception of certain liabilities that qualify for the amortized cost option, all other changes in fair value would be recognized in other comprehensive income (OCI) each reporting period. Currently, unrealized gains and losses only on available for sale instruments are recognized in OCI.

Under the proposal, financial instruments held for sale or settlement would be measured at fair value with all changes recognized in net income.

Similar to financial assets, many financial liabilities would be measured at fair value (with amortized cost also being presented for certain liabilities). In addition, core deposit liabilities would be remeasured each period using a current value method intended to reflect the economic benefit that an entity receives from this lower cost, stable funding source.

Credit Impairment and Loan Loss Provisioning

The proposal would utilize a single credit impairment model for both loans and debt securities. The impairment model would eliminate the “probable” threshold for recognizing credit losses on loans.

The proposed guidance on credit impairment is intended to establish a model for recognition and measurement of impairment based on an entity’s expectations about the collectibility of cash flows. An entity’s expectations would be based on all available information relating to past events and existing conditions but the entity cannot consider potential future events beyond the reporting date.

Effective Date

The International Accounting Standards Board (IASB), the international accounting standard-setter, also currently has a financial instruments proposal out for comment. Following FASB’s September 30th comment deadline, FASB and the IASB will review together the comment letters and other feedback received in an effort to reconcile differences between the Boards’ views and possibly issue a uniform final rule on accounting for financial instruments. FASB hopes to issue its rule by June 30, 2011—regardless of whether the Boards have reconciled.

While no effective date has been agreed upon, commenters should assume that the changes included in the proposal would not be effective before January 1, 2013. Additionally, nonpublic entities—including credit unions—with less than $1 billion in total assets would be allowed an extra four years to implement the new requirements relating to loans, loan commitments, and core deposit liabilities that meet certain criteria.


Comments are due to FASB by September 30, 2010. Please submit any comments to CUNA by September 6.

Please e-mail your responses to Senior Vice President and Deputy General Counsel Mary Dunn at mdunn@cuna.coop and Regulatory Counsel Luke Martone at lmartone@cuna.coop. You may also contact us at (800) 356-9655, ext. 6743, if you have any questions. Click here for the exposure draft.


DESCRIPTION OF THE PROPOSED RULE

Measurement

Application of Fair Value Measurement

The proposal generally requires that an entity measure its financial assets and financial liabilities at fair value on each reporting date unless the financial instruments qualify for an exception. All changes in value of instruments measured at fair value would be included in net income, except for specified changes in value of certain debt instruments.

For certain instruments, an entity could recognize a portion of the change in fair value in other comprehensive income (OCI), instead of in net income. Partial recognition in OCI would be limited to debt instruments: for which the creditor/investor will recover the principal; for which the entity’s business strategy is to collect or pay the related cash flows; and that cannot contractually be prepaid. In evaluating its business strategy, an entity would need to do so on the basis of how it manages its financial instruments rather than on its intent for an individual instrument. Subsequent to an entity’s decision on how it will recognize qualifying changes for an instrument, the entity would be prohibited from using a different method.

An entity could recognize in OCI only the portion of the change in the instrument’s fair value attributable to credit impairment. For such changes recognized in OCI, an entity would include in net income any realized gains or losses from sales and settlements for the reporting period.

Exceptions to Fair Value Measurement

Demand Deposit Liabilities

Under the proposal, an entity would be required to measure its core deposit liabilities (these are deposits without a maturity considered a stable source of funds) each reporting period at the present value of the average core deposit discounted at the difference between the alternative funds rate (this is the cost of the next available source of funds if there were no core deposits) and the all-in-cost-to-service rate (this is the total cost to service core deposits) over the implied maturity of the deposits (this is management’s assessment of the average life of each type of account). This method of measurement is known as the “core deposit liabilities remeasurement approach.” An entity would need to determine the remeasurement amount separately for each major type of demand deposit—such as, non-interest-bearing checking, savings, and money market accounts.

A deposit liability that is not a core deposit liability would be measured at its fair value. However, the maturity of some non-core deposit liabilities may be so short that their face amount reasonably approximates their fair value.

Investments Redeemable Only for a Specified Amount

Under the proposal, investments that are not held for capital appreciation and can be redeemed with the issuer only for a specified amount would be measured at redemption value; this approach is intended to approximate fair value. This category of instruments would include National Credit Union Share Insurance Fund (NCUSIF) deposits, as well as stock in a Federal Home Loan Bank or Federal Reserve Bank. Currently, NCUSIF deposits are measured at their book value.

Credit Impairment

The proposed guidance on credit impairment establishes a model for recognition and measurement of impairment based on an entity’s expectations about the collectibility of cash flows. An entity’s expectations would be based on all available information relating to past events and existing conditions but it cannot consider potential future events beyond the reporting date.

The impairment guidance would apply to financial assets measured at fair value with qualifying changes recognized in OCI, as well as assets that are redeemable only for a specified amount (e.g., NCUSIF deposits).

Evaluating Credit Impairment

Under the proposal, an entity would recognize a credit impairment in net income at the end of the reporting period for a financial asset when it does not expect to collect: all contractual amounts due for originated assets; and all amounts initially expected for purchased assets. This means that an entity could not wait until a credit loss is “probable” to recognize an impairment.

The proposed guidance would require an entity to consider both the timing and amount of the cash flows expected to be collected. If an entity’s expectation of the amount of cash flows expected decreases, a financial asset would be considered impaired. If an entity expects that it will not collect amounts due on an asset on the dates originally anticipated, but it expects to recover any shortfall through existing collateral, the asset would not be considered impaired. If cash flows expected are delayed and the entity expects it will not receive interest on the delayed cash flows, the asset would be considered impaired. However, an asset would not be impaired if the entity expects to collect all amounts due, including interest for the period of delay.

In determining whether a credit impairment exists, an entity would need to consider all available information relating to past events and existing conditions and their implications for collectibility of cash flows at the date of the financial statements. In estimating cash flows expected to be collected, an entity would assume that the economic conditions existing at that point in time would remain unchanged for the remaining life of the asset. An entity would be prohibited from forecasting future events or economic conditions in determining impairment.

Measurement of Credit Impairment

An entity would recognize any unfavorable change in cash flows expected to be collected as a credit impairment in net income and would establish or increase the allowance for credit losses related to the financial asset by the same amount. In addition, if the entity expects a favorable change in cash flows as compared with its previous expectations, it would reverse the previously recognized impairment expense and decrease the allowance for credit losses.

An entity would be required to evaluate and measure impairment of certain financial assets together in a pool. This requirement would apply to groups of assets that, based on their shared characteristics (such as collateral type or geographic location), may have some credit impairment even though the impairment cannot be identified with a specific asset. In determining the amount of impairment, an entity would consider historical loss for assets with those same characteristics. Any impairment would be recognized in net income. The amount of impairment (or reversal of) would be the difference between the allowance for credit losses for the pool—determined by applying the historical loss rate to the current principal balance of the pool—and the existing balance of the allowance attributable to that pool of financial assets.

For financial assets that are individually evaluated and determined to be impaired, the amount of impairment would be determined by using either: a present value technique; or the practical expedient for certain loans (discussed below). In estimating the present value of cash flows expected to be collected, an entity would consider past events and existing economic conditions, which may include historical statistics related to financial assets with similar characteristics. If the present value of cash flows expected to be collected is less than the amortized cost of the asset, a credit impairment would be recognized in net income and an allowance for credit losses would be established. For individually evaluated impaired assets, that also share similar risk characteristics with other impaired assets, an entity could aggregate the assets to measure impairment using a present value technique.

Subsequent measurement of an impairment would be recognized in net income on the basis of changes in the present value of cash flows expected to be collected.

Loans Modified or Restructured in a Troubled Debt Restructuring

A loan that is modified or restructured in a troubled debt restructuring (a TDR loan) is an impaired loan. If the TDR loan was previously included in a pool of assets collectively evaluated for impairment, the loan would need to be removed from the pool and reevaluated for impairment on an individual basis.

For a TDR loan, the contractual terms of the loan agreement refer to the terms of the original agreement, not the restructured one. Similarly, the effective interest rate for a TDR loan is based on the original contractual rate, not the rate in the TDR agreement. Therefore, the interest rate used to discount cash flows expected to be collected on a TDR loan would be the same rate used on an impaired loan.

Practical Expedient for Measuring Impairment

As a practical expedient, an entity could measure credit impairment for an individually impaired financial asset on the basis of the fair value of the collateral if the asset is collateral-dependent. A creditor would be required to measure impairment on the basis of the fair value of the collateral if it expects foreclosure.

If the fair value of the collateral is less than the amortized cost, an entity would recognize an impairment in net income and establish an allowance for credit losses. Subsequent measurement of an impairment would be recognized in net income on the basis of changes in the fair value of the collateral.

Presentation in Financial Statements

Balance Sheet

Under the proposal, the balance sheet would need to include financial assets and financial liabilities separately depending on whether all changes in their fair value are recognized in net income or whether qualifying changes in fair value are recognized in OCI.

For financial assets and liabilities with all changes in fair value recognized in net income, the balance sheet would need to include:

For financial assets and liabilities with qualifying changes in fair value recognized in OCI, the balance sheet would include:

For core deposit liabilities, the balance sheet would include:

The balance sheet would need to show amounts included in accumulated OCI related to qualifying changes in an instrument’s fair value or qualifying changes in the instrument’s remeasurement amount that are recognized in OCI.

Statement of Comprehensive Income

An entity would be required to separately present within net income on the statement of comprehensive income the aggregate amount for realized and unrealized gains or losses on financial instruments for which all changes in fair value are recognized in net income.

For financial assets and liabilities for which qualifying changes in fair value are recognized in OCI, net income would include:

For qualifying financial liabilities subsequently measured at amortized cost, net income would separately include:

An entity would be permitted to present changes in the remeasured amount of certain core deposit liabilities in OCI. However, entities that instead choose to present these changes in net income would be required to present separately on the statement of comprehensive income, an aggregate amount for realized and unrealized gains or losses on the core deposit liabilities.

Effective Date

The International Accounting Standards Board (IASB), the international accounting standard-setter, has a similar proposal out for comment. Following the September 30th comment deadline, FASB and the IASB will review together the comment letters and other feedback received in an effort to reconcile differences between the Boards’ views and possibly issue a uniform final rule on accounting for financial instruments. FASB hopes to issue its rule by June 30, 2011—regardless of whether the Boards have reconciled.

While no effective date has been agreed upon, commenters should assume that the changes included in the proposal would not be effective before January 1, 2013. In addition, nonpublic entities—including credit unions—with less than $1 billion in total assets would be allowed an extra four years to implement the new requirements related to loans, loan commitments, and core deposit liabilities that meet certain criteria.

Specifically, the four-year deferral would apply to the proposed provisions related to:


QUESTIONS TO CONSIDER

  1. Do you agree with the scope of financial instruments included in the proposal? Which instruments should be excluded or which others should be included?
















  2. Should there be a single initial measurement principle regardless of whether changes in fair value of a financial instrument are recognized in net income or OCI? Should that principle require initial measurement at the transaction price or fair value?
















  3. For financial instruments initially measured at the transaction price, do you believe that the proposed guidance is operational to determine whether there is a significant difference between the transaction price and fair value?
















  4. The Board believes that both fair value information and amortized cost information should be provided for instruments an entity intends to hold for collection or payment of cash flows. Most Board members believe that this information should be provided in the totals on the face of the financial statements. Some Board members believe fair value should be presented parenthetically on the balance sheet. Do you believe the default measurement attribute for financial instruments should be fair value? Do you believe that certain financial instruments should be measured using a different measurement attribute?
















  5. The proposed guidance would require that credit impairments and reversals, and realized gains and losses be recognized in net income for financial instruments that meet the criteria for qualifying changes in fair value to be recognized in OCI. Do you believe that any other fair value changes should be recognized in net income for these financial instruments?
















  6. Should the subsequent measurement principles be the same for financial assets and financial liabilities?
















  7. The proposed guidance would require an entity to decide whether to measure a financial instrument at fair value with all changes in fair value recognized in net income, at fair value with qualifying changes in fair value recognized in OCI, or at amortized cost (for certain financial liabilities) at initial recognition. An entity would be prohibited from subsequently changing that decision. Do you agree that reclassifications should be prohibited? Are there circumstances in which reclassifications should be permitted or required?
















  8. The proposed guidance would require an entity to measure its core deposit liabilities at the present value of the average core deposit amount discounted at the difference between the alternative funds rate and the all- in-cost-to-service rate over the implied maturity of the deposits. Do you believe that this remeasurement approach is appropriate? Do you believe that the remeasurement amount should be disclosed in the notes to the financial statements rather than on the face?
















  9. Do you agree that a financial liability should be permitted to be measured at amortized cost if it meets the criteria for recognizing qualifying changes in fair value in OCI and if measuring the liability at fair value would create or exacerbate a measurement attribute mismatch?
















  10. Do you agree with the proposed requirement to measure of certain investments that can be redeemed only for a specified amount—such as deposits in the National Credit Union Share Insurance Fund—based on their redemption value?
















  11. Do you believe that the recognition of qualifying changes in fair value in OCI will provide decision-useful information for financial instruments an entity intends to hold for collection or payment of cash flows?
















  12. The proposed guidance would establish fair value with all changes in fair value recognized in net income as the default classification and measurement category for financial instruments. An entity could choose to measure any instrument within the scope of this proposal at fair value with changes recognized in net income, except for core deposit liabilities which would be valued using a remeasurement approach. Do you believe that a default classification and measurement category should be provided for financial instruments that would otherwise meet the criteria for qualifying changes to be recognized in OCI?
















  13. Do you believe that the proposed criteria for recognizing qualifying changes in fair value in OCI are operational?
















  14. Do you believe that measuring financial liabilities at fair value is operational?
















  15. Do you believe that the proposed criteria are operational to qualify for measuring a financial liability at amortized cost?
















  16. The proposed guidance would require an entity to measure its core deposit liabilities at the present value of the average core deposit amount discounted at the difference between the alternative funds rate and the all- in-cost-to-service rate over the implied maturity of the deposits. Do you believe that this remeasurement approach is operational? Do you believe that the remeasurement approach is clearly defined?
















  17. For financial instruments measured at fair value with qualifying changes recognized in OCI, do you believe that the presentation of amortized cost, the allowance for credit losses, the amount needed to reconcile amortized cost less the allowance for credit losses to fair value, and fair value on the face of the balance sheet would provide decision-useful information?
















  18. The proposed guidance would require an entity to recognize a credit impairment immediately in net income when the entity does not expect to collect all contractual amounts due for originated financial assets and all amounts originally expected to be collected for purchased financial assets.

    The IASB exposure draft on impairment would require an entity to forecast credit losses upon acquisition and allocate a portion of the initially expected credit losses to each reporting period as a reduction in interest income by using the effective interest rate method. Thus, initially expected credit losses would be recorded over the life of the financial asset as a reduction in interest income. If an entity revises its estimate of cash flows, the entity would adjust the carrying amount (amortized cost) of the asset and immediately recognize the amount of the adjustment in net income as an impairment gain or loss.

    Which approach do you favor?
















  19. For a financial asset evaluated in a pool, the proposed guidance does not specify a particular methodology to be applied for determining historical loss rates. Should a specific method be prescribed? What method would you recommend?
















  20. Do you agree that if an entity subsequently expects to collect more cash flows than originally expected to be collected for a purchased financial asset, the entity should recognize no immediate gain in net income but should adjust the effective interest rate so that the additional cash flows are recognized as an increase in interest income over the remaining life of the asset?
















  21. If a financial asset that is evaluated for impairment on an individual basis has no indicators of being individually impaired, the proposed guidance would require an entity to determine whether assessing the asset together with other assets that have similar characteristics indicates that a credit impairment exists. The amount of any credit impairment would be measured by applying the historical loss rate applicable to the group of similar assets to the individual asset. Do you agree with this requirement?
















  22. The credit impairment model would remove the probable threshold. Thus, an entity would no longer wait until a credit loss is probable to recognize an impairment, but instead would recognize the impairment immediately in net income when the entity does not expect to collect all of the contractual cash flows. This will result in credit impairments being recognized earlier than they are under current GAAP. Do you believe that removing the probable threshold so that impairments are recognized earlier provides more decision-useful information?
















  23. The proposed guidance would require that in determining whether a credit impairment exists, an entity consider all available information relating to past events and existing conditions and their implications for the collectibility of cash flows at the date of the financial statements. An entity would assume that the economic conditions existing at the end of the reporting period would remain unchanged for the remaining life of the asset and would not forecast future events or economic conditions. In contrast, the IASB exposure draft on impairment proposes an expected loss approach and would require an entity to estimate credit losses on the basis of probability-weighted possible outcomes. Do you agree that an entity should assume that economic conditions would remain unchanged in determining, or do you believe that an expected loss approach that would include forecasting future events or conditions would provide more decision-useful information?
















  24. The proposed guidance would require that an appropriate historical loss rate be determined for each individual pool of similar financial assets. Historical loss rates would reflect cash flows that the entity does not expect to collect over the life of the assets in the pool. Do you agree with that approach?
















  25. Do you agree with the proposed delayed effective date for certain aspects of the proposed guidance for nonpublic entities with less than $1 billion in assets? Would a different asset size threshold be more appropriate?
















  26. How much time do you believe is needed to implement the proposed guidance?
















  27. Any other comments or questions regarding the proposal?
















Eric Richard • General Counsel • (202) 508-6742 • erichard@cuna.com
Mary Mitchell Dunn • SVP & Deputy General Counsel • (202) 508-6736 • mdunn@cuna.com
Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com
Luke Martone • Senior Regulatory Counsel • (202) 508-6743 • lmartone@cuna.com