On April 25, 2019, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2019-04, Codification Improvements to Topic 326, Financial Instruments—Credit Losses; Topic 815, Derivatives and Hedging; and Topic 825, Financial Instruments.
This new update clarifies and improves guidance related to the recently issued standards on credit losses, hedging and recognition and measurement of financial instruments. Amendments in the update apply to all reporting entities within the scope of these topics. The changes were made in response to certain areas in ASUs 2016-01, Financial Instruments; 2016-13, Financial Instruments–Credit Losses; and 2017-12, Derivatives and Hedging that were questioned by stakeholders.
An overview of some of the update’s key provisions follows, including accounting policy elections, effective dates, and more.
Current Expected Credit Losses (CECL)
The amendments provide entities with various measurement alternatives and policy elections related to accounting for credit losses on accrued interest receivable balances. These include options to:
- Measure an allowance for credit losses on accrued interest receivables separately from the other components of the amortized cost basis
- Not measure an allowance for credit losses on accrued interest receivables if the entity writes off the uncollectible accrued interest receivables in a timely manner
- Write off accrued interest amounts by reversing interest income or recognizing credit loss expense, or a combination of both
- Determine where to present and disclose accrued interest receivables and the corresponding allowance for credit losses
Entities can also elect a practical expedient to separately disclose the total amount of accrued interest included in the amortized cost basis as a single balance to meet certain disclosure requirements. These accounting policy elections all require certain disclosures.
Recoveries and Renewal Options
The amendments clarify that the estimated allowance for credit losses should include all expected recoveries of financial assets and trade receivables that were previously written off and expected to be written off. The amount of expected recoveries shouldn’t exceed the aggregate of amounts previously written off and expected to be written off by the entity. Similarly, the amendments clarify that for collateral-dependent financial assets, an allowance for credit losses that’s added to the amortized cost basis of the asset, a negative allowance, shouldn’t exceed amounts previously written off.
Additionally, the amendments clarify that when determining the contractual term of a financial asset, an entity should include contractual extensions or renewal options—other than those accounted for as derivatives—that aren’t unconditionally cancellable by the entity.
Interest Rate Environments and Prepayments
The amendments also allow entities to use projections of future interest rate environments when using a discounted cash flow method to measure expected credit losses on variable-rate financial instruments. When doing so, entities must use the same projections in determining the effective interest rate to discount those expected cash flows.
Entities can also now make an accounting policy election to adjust the effective interest rate used to discount expected future cash flows for expected prepayments to appropriately isolate credit risk when determining the allowance for credit losses.
The effective interest rate is required to be adjusted for expected prepayments when entities use projections of future interest rate environments to measure credit losses on variable-rate financial instruments. Additionally, the effective interest rate can’t be adjusted for subsequent changes in expected prepayments if the financial asset is restructured in a troubled debt restructuring.
The amendments clarify guidance in several other areas, including:
- Transfers of loans and debt securities between classifications or categories
- Estimated costs to sell collateral
- The scope of guidance applicable to reinsurance recoverables
- Line-of-credit arrangements converted to term loans
The effective dates and transition requirements for the credit losses amendments are the same as those in ASU 2016-13 for entities that haven’t yet adopted ASU 2016-13.
For entities that have already adopted ASU 2016-13, the amendments are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The amendments should be applied on a modified-retrospective basis, and early adoption is permitted.
Partial-Term Fair Value Hedges
The amendments clarify that entities may use an assumed term to measure the change in fair value of a hedged item only for changes attributable to interest rate risk. Further, the amendments clarify that an assumed term may be used to measure changes attributable to interest rate risk when the hedged item is designated in a hedge of both interest rate risk and foreign exchange risk. However, in those cases, changes in the spot exchange rate must be used to measure the change in carrying value attributable to foreign exchange risk.
Additionally, the update clarifies that multiple partial-term fair value hedging relationships of a single financial instrument may be outstanding at the same time, and that if an entity elects to amortize the basis adjustment during an outstanding partial-term hedge, that basis adjustment must be fully amortized before the hedged item’s assumed maturity date.
Not-for-Profit Entities and Private Companies
The amendments clarify that not-for-profit entities that don’t separately report earnings can’t elect the amortization approach for amounts excluded from the assessment of effectiveness for fair value hedging relationships.
The amendments also clarify that certain private companies must document the last-of-layer hedge designation analysis concurrently with hedge inception, and that certain not-for profit entities can apply the same subsequent quarterly hedge effectiveness timing relief as private companies.
The amendments clarify guidance in several other areas, including:
- Fair value hedge basis adjustment disclosures for available-for-sale debt securities
- Use of the contractually specified interest rate under the hypothetical derivative method
- Application of the first-payments-received cash flow hedging technique to changes in overall cash flows on a group of variable interest payments
The amendments address various stakeholder questions on the transition guidance in ASU 2017-12, including the following:
- Transition adjustments to amend the measurement methodology of a hedged item in a fair value hedge of interest rate risk should be made as of the initial application date of ASU 2017-12, as opposed to the date of adoption.
- An entity may rebalance its fair value hedging relationships of interest rate risk when it modifies the measurement methodology from total contractual coupon cash flows to the benchmark rate component of the contractual coupon cash flows.
- An entity may transition from a quantitative method of hedge effective assessment to the critical terms match method, without dedesignating the existing hedging relationship.
- A debt security reclassified from held-to-maturity to available-for-sale doesn’t call into question the entity’s classification of other held-to-maturity securities, isn’t required to be designated in a last-of-layer hedging relationship, and isn’t prohibited from being sold by the entity after reclassification.
The effective dates and transition requirements for the hedging amendments are the same as those in ASU 2017-12 for entities that haven’t yet adopted ASU 2017-12.
For entities that have already adopted ASU 2017-12, the amendments are effective as of the beginning of the entity’s next annual period, and early adoption is permitted. Entities may choose to apply the amendments either retrospectively or prospectively, with certain exceptions.
Measurement Alternative and Exchange Rates
The amendments require that an equity security without a readily determinable fair value that’s accounted for under the measurement alternative in accordance with ASC 321-10-35-2 must be remeasured at fair value when an orderly transaction is identified for an identical or similar investment of the same issuer. The update clarifies that the measurement alternative is a nonrecurring fair value measurement, therefore the applicable disclosure requirements in ASC 820 should be made.
The amendments further clarify that a security without a readily determinable fair value that’s accounted for under the measurement alternative should be remeasured at historical exchange rates. The rate used should be the rate as of the later of the acquisition date or the most recent date on which the equity security was adjusted to fair value.
The amendments specifically name health and welfare plans accounted for in accordance with ASC Topic 965 in the list of entities excluded from the scope of ASC Topic 320 or 321.
The amendments clarify that only public business entities are required to provide the fair value disclosure requirements for financial instruments not measured at fair value on the balance sheet.
The financial instruments amendments are effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted as long as the entity has adopted ASU 2016-01.
The amendments should be applied on a modified-retrospective basis—except those related to equity securities without readily determinable fair values that are measured using the measurement alternative, which should be applied prospectively.
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