Complying With the New Fair Value Disclosure Requirements in 2018

By Rick L. Childs, CPA, and Charles F. Clow, CPA  
12/13/2017

A new Financial Accounting Standards Board (FASB) standard makes several substantive changes to U.S. generally accepted accounting principles (GAAP). Among the changes are new requirements for determining the fair value disclosure of banks’ loan portfolios.

Although the final FASB standard on the classification and measurement of financial instruments – Accounting Standards Update (ASU) 2016-01, “Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities” – does not contain some of the more significant changes originally proposed, it does make a handful of important changes to U.S. GAAP. Except for two provisions that could have been early adopted, the changes begin to take place in the first quarter of 2018.

One change is a new requirement regarding the disclosure of fair value of financial instruments carried at amortized cost under Accounting Standards Codification (ASC) Topic 825, “Financial Instruments.” The required disclosure, originated in FASB Statement 107, “Disclosures About Fair Value of Financial Instruments,” has been in place since the early 1990s. The new standard requires a change in how the fair value is determined. Instead of permitting the use of entrance pricing, exit pricing instead must be used to determine fair value. For many banks, the methodology used to prepare this footnote disclosure likely will be a significant change, especially when determining the fair value of loan portfolios.

Who Is Affected?

The new requirement applies only to “public business entities” (PBEs). In fact, the table for non-PBEs was removed from the new standard, providing many banks with relief. However, the PBE definition encompasses banks beyond those that file or furnish financial statements with the U.S. Securities and Exchange Commission (SEC). Given that the definition is broader than just those filing with the SEC, management will need to analyze whether the holding company or bank qualifies as a PBE. In October, the American Institute of CPAs (AICPA) published a Technical Question and Answer (TQA) to address the most common issues.

Is Your Bank a Public Business Entity (PBE)?

According to the FASB’s Master Glossary, a public business entity is a business entity that meets any one of the following criteria:

  • It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
  • It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
  • It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
  • It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
  • It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including footnotes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
An entity may meet the definition of a public business entity solely because its financial statements or financial information is included in another entity’s filing with the SEC. In that case, the entity is only a public business entity for purposes of financial statements that are filed or furnished with the SEC.

 

The Details

The new requirement eliminates the entrance price approach, which permitted banks to use a simplified calculation to determine the fair value of their loan portfolios for the purposes of disclosure. The entrance price approach determines the fair value by using the current rates at which similar loans with the same remaining maturities would be made to borrowers with similar credit ratings.

The new FASB standard requires the disclosed fair value, for those entities that qualify as PBEs, to be based on an exit price calculation, which takes into account factors such as liquidity, credit, and the nonperformance risk of the loans.

Many banks currently use their in-house or third-party asset liability management (ALM) systems to generate the entrance price fair value under today’s standard. Typically, these systems will not be adequate for performing the granular analysis and specialized fair value calculations required for exit pricing under the new standard. Because there seldom are observable quoted prices for identical or similar assets carried in a bank’s loan portfolio, Level 3 inputs (defined by ASC 820 as “unobservable inputs”)1  primarily are used to determine fair value using exit pricing.

The change is effective for fiscal years beginning after Dec. 15, 2017, including interim periods in those years. For calendar year-ends, the change is effective for March 31, 2018, interim financial statements.

Entrance Price vs. Exit Price

The following table compares the entrance price approach permitted and commonly used under current accounting standards with the exit price approach required under ASU 2016-01:

Component Entrance Price Exit Price
Discount Rate For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are assumed to approximate carrying values. Fair values for fixed rate loans are estimated using discounted cash flow using interest rates currently offered on loans with similar terms to borrowers of similar credit quality. Independent discount rate calculation must consider the return required by market participants relative to the cash flow expectations of the loan. This approach considers a market participant’s cost of funds, liquidity premiums, capital charges, servicing charges, expectations of future rate movements (for variable rate loans), and any other adjustments to the discount rate perceived by the market.
Credit Risk The allowance for loan and lease losses (ALLL) is deducted from the present value of the financial asset, discounted using the entrance price discount rate. In other words, the ALLL is used as a proxy for the credit risk. Two options exist:
1. Use historical data or market data to derive overall loss rates by product type (or loan-specific, where available), and develop the probability of default, loss given default, and recovery lag assumptions to be embedded into a discounted cash flow model. Given the discounted cash flow approach, timing of losses is a factor, and loss curves can be used to better forecast when losses will occur.
2. Build the credit risk adjustment into the discount rate. Market data on credit risk adjustments to the discount rate are not widely available; therefore, this approach is not widely used because of difficulties in anchoring the credit risk adjustments.
Prepayment Risk Incorporating prepayment assumptions is not explicitly required. Capture historical data or obtain market data to embed single monthly mortality prepayments into a discounted cash flow model.

 

 

1 The FASB defines “unobservable inputs” as “Inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability.”

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