Proposed Expansion of Fair Value Accounting

6/10/2010

By Joseph M. Press, CPA, CFE

The Financial Accounting Standards Board (FASB) continued its quest to expand mark-to-market rules on May 26, 2010, when it issued an Exposure Draft Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. If adopted, all entities that have financial instruments will be affected. However, banks that accounted for their financial assets at amortized cost will be most affected.

The key changes effecting banks are:

• Financial instruments (think loans and debt securities) for which a bank’s business strategy is to hold for collection or payment(s) of contractual cash flows would be accounted for much as “available for sale” securities are accounted for now. The financial statements would include a reconciliation from amortized cost to fair value on the face of the balance sheet. This “business strategy” approach would preserve most of the existing aspects of reporting net income, with changes in fair value reported in Other Comprehensive Income. The category of “held to maturity” used now for certain debt securities would be eliminated.
• A bank would need to measure deposit liabilities, including core deposit liabilities, at fair value.
• Accounting for loan losses would change from the current “incurred loss” model where losses are accrued when probable and reasonably estimable to an “expected loss” model, which employs a more forward looking approach.

A more detailed discussion of the definitions, concepts, and methodologies to implement these changes will be the topic of future articles.

The proposed guidance applies to all entities and is estimated to be effective in 2013. However, for a nonpublic entity with less than $1 billion in total consolidated assets, the effective date for certain requirements is deferred for an additional four years. For these entities, loans, loan commitments and core deposit liabilities would not be accounted for at fair value in the financial statements until the delayed date. However, the fair value of loans would be disclosed in the notes to the financial statements.

We see several problems with this proposal:

• Measuring loans that a bank has no intention of selling at fair value is contrary to its business model.
• The process of fair valuing loans will introduce subjective assumptions that will vary from bank to bank. This fact will not improve transparency or comparability.
• For community banks, the accounting burden of fair valuing loans will outweigh the questionable benefits.

This article is a short summary of the proposed standard which runs 218 pages. We recommend that all interested parties obtain a copy of the complete Exposure Draft at the FASB website and familiarize themselves with its provisions. The comment period is open until September 30, 2010, and collectively, we still have an opportunity to significantly impact the final provisions of this proposal.