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.
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.
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.”