The Guidance

In January of 2016, the FASB issued Accounting Standards Updates 2016-01, Financial Instruments – Overall, which requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. This guidance changes significantly where temporary variations in the valuation of such equity investments are presented on the financial statements: Other Comprehensive Income vs. Net Income.

The Old Way

Before this standard came out, Companies that were reporting investments using their respective fair values were able to determine the treatment of how temporary changes in equity securities’ valuations are recorded in the statement of net income and comprehensive income based on the two methods Available-for-sale (AFS) method, or Trading method. The respective methods had the following difference in the way they are accounted for in the financial statements:

Category Amount Reported in the Balance Sheet Reporting Gains and Losses
Trading Fair Value Include unrealized gains and losses in current period earnings which impacts net income (above the line)

 

Available-for-sale (AFS) Fair Value Charge realized gains and losses and non-temporary unrealized losses to earnings; report other unrealized gains and losses as other comprehensive income (below the line)

 

The decision to choose between Trading and AFS category was based on the Company’s intention regarding how long they hold on to these investments.

The New Way

However, with the introduction of ASU 2016-01, the option to choose how a Company determines to treat the temporary changes in the fair value of equity security investment changes is now limited. All equity security investments presented at fair value must essentially be accounted for using the Trading method with changes in the values being recorded in current period earnings, impacting the net income.

 

 

Other Changes

This guidance also introduces other additional changes which are summarized in the table below:

Topic Previous Accounting New Accounting
Investments in equity securities without readily determinable fair values Cost method (i.e., recorded at cost with dividends recognized in income when received). Subject to impairment. If fair value is not readily determinable the investments may be recorded at cost, subject to impairment, and adjusted through net income for observable price changes. If the alternative is elected, new disclosure requirements apply.
Impairment of equity securities without readily determinable fair values Impairment based on a two-step test: (1) determine whether the security is impaired and (2) determine if the decline is other than temporary. Impairment losses that are other than temporary are recognized in net income. Impairment based on a one-step test: perform a qualitative assessment to determine if impairment exists. If so, write the investment down to its fair value through net income.
Financial liabilities under the fair value option Recognize all changes in fair value in net income. Recognize changes in fair value due to instrument-specific credit risk in other comprehensive income. Reclassify those amounts to net income when the liability is derecognized.
Disclosure of financial instruments Nonpublic entities are required to disclose the fair values of financial instruments if they have—

·         Total assets in excess of $100 million, or

·         Financial instruments accounted for as derivatives (with certain exceptions).

The disclosure requirement is eliminated.
Presentation of financial instruments No existing requirement to disaggregate financial assets and financial liabilities by measurement category and type of financial asset. Present financial assets and financial liabilities separately in the balance sheet or notes to the financial statements, grouped by measurement category (i.e., cost, fair value—net income, or fair value—OCI) and type of financial asset (i.e., loans/receivables or securities).
Valuation allowance for deferred tax assets resulting from unrealized losses on available-for-sale debt securities Deferred tax assets resulting from unrealized losses on available-for-sale debt securities may be evaluated (1) separately from other deferred tax assets or (2) in combination with other deferred tax assets when determining the need for a valuation allowance. Deferred tax assets resulting from unrealized losses on available-for-sale debt securities should be evaluated in combination with other deferred tax assets when determining the need for a valuation allowance.

 

Effective Date

This standard is already effective of public companies with fiscal years beginning after December 15, 2018. For private companies, the guidance is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted only for private companies. Any adjustment at adoption will be made by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. However, the ASU requires that the amendments related to equity investments without readily determinable fair values (including disclosure requirements) be applied prospectively to all investments that exist as of the date of adoption.

Plan for Volatility in Financial Statements

With this new guidance coming into effect, Companies should plan for higher volatility in their net income based on how the equity security market performs. This will undoubtedly place more pressure on investment management teams to rethink their investment strategies and potentially take less risky investments that may introduce any significant volatility to their organization’s financial statements.

For more information, contact Andrew Wan, CPA, CFE.