SFAS 159 - 4/12/2007SFAS 159
A Great Opportunity for Credit Unions!
Anderson & French, P.C.
In February 2007, the Financial Accounting Standards Board (FASB) issued a new Statement of
Financial Accounting Standards: No. 159 (SFAS 159). SFAS 159, entitled The Fair Value Option for Financial Assets and Financial Liabilities, contains some interesting accounting provisions that may be very beneficial for some credit unions.
In a nutshell, SFAS 159 allows all credit unions the ability to mark certain assets and liabilities to fair market value (FMV).
The following items are eligible for the FMV measurement option:
1. Recognized financial assets and financial liabilities except:
a. An investment in a subsidiary that the credit union is required to consolidate.
b. An interest in a variable interest entity that the credit union is required to consolidate.
c. Employers’ and plans’ obligations (or assets representing net over funded positions) for pension benefits, other postretirement benefits (including health care and life insurance benefits), post employment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements.
d. Financial assets and financial liabilities recognized under leases.
e. Deposit liabilities, withdrawable on demand, of banks, savings and loan associations, credit unions, and other similar depository institutions.
f. Financial instruments that are, in whole or in part, classified by the issuer as a component of shareholder’s equity (including “temporary equity”).
2. Firm commitments that would otherwise not be recognized at inception and that involve only financial instruments.
3. Nonfinancial insurance contracts and warranties that the insurer can settle by paying a third party to provide those goods or services.
4. Host financial instruments resulting from separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument.
The fair value option established by this Statement permits all credit unions to choose to measure eligible items at fair value at specified election dates.
The fair value option:
1. May be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method.
2. Is irrevocable (unless a new election date occurs).
3. Is applied only to entire instruments and not to portions of instruments.
SFAS 159 is effective as of the beginning of a credit union’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of 2007.
No credit union is permitted to apply this Statement retrospectively to fiscal years preceding the effective date unless the credit union chooses early adoption. The choice to adopt early should be made within 120 days of the beginning of the fiscal year (April 30, 2007).
Fair value—The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Financial asset—Cash, evidence of an ownership interest in an entity, or a contract that conveys to one credit union a right (1) to receive cash or another financial instrument from a second entity or (2) to exchange other financial instruments on potentially favorable terms with the second entity.
Financial liability—A contract that imposes on one entity an obligation (1) to deliver cash or another financial instrument to a second entity or (2) to exchange other financial instruments on potentially unfavorable terms with the second entity.
Firm commitment—An agreement with an unrelated party, binding on both parties and usually legally enforceable.
All credit unions may elect the fair value option for the following items (eligible items):
a. A recognized financial asset and financial liability.
b. A firm commitment that involves only financial instruments.
c. A written loan commitment.
d. The rights and obligations under an insurance contract that is not a financial instrument.
e. The rights and obligations under a warranty that is not a financial instrument.
The fair value option may be elected for a single eligible item without electing it for other identical items with the following four exceptions:
a. If multiple advances are made to one borrower pursuant to a single contract (such as a line of credit or a construction loan) and the individual advances lose their identity and become part of a larger loan balance, the fair value option shall be applied only to the larger balance and not to each advance individually.
b. If the fair value option is applied to an investment that would otherwise be accounted for under the equity method of accounting, it shall be applied to all of the investor’s financial interests in the same entity (equity and debt, including guarantees) that are eligible items.
c. If the fair value option is applied to an eligible insurance or reinsurance contract, it shall be applied to all claims and obligations under the contract.
d. If the fair value option is elected for an insurance contract (base contract) for which integrated or nonintegrated contract features or coverages (some of which are called riders) are issued either concurrently or subsequently, the fair value option also must be applied to those features or coverages. The fair value option cannot be elected for only the nonintegrated contract features or
Credit unions shall report assets and liabilities that are measured at fair value pursuant to SFAS 159
in a manner that separates those reported fair values from the carrying amounts of similar assets and liabilities measured using another measurement attribute.
To accomplish that, a credit union shall either:
a. Present the aggregate of fair value and non-fair-value amounts in the same line item in the statement of financial position and parenthetically disclose the amount measured at fair value included in the aggregate amount
b. Present two separate line items to display the fair value and non-fair-value carrying amounts.
A credit union may elect the fair value option for eligible items that exist at that date. The credit union shall report the effect of the first remeasurement to fair value as a cumulative-effect adjustment to the opening balance of undivided earnings.
The difference between the carrying amount and the fair value of eligible items for which the fair value option is elected at the effective date shall be removed from the statement of financial position and included in the cumulative-effect adjustment. Those differences may include, but are not limited to:
a. Unamortized deferred costs, fees, premiums, and discounts
b. Valuation allowances (for example, allowances for loan losses)
c. Accrued interest, which would be reported as part of the fair value of the eligible item.
Available-for-sale and held-to-maturity securities held at the effective date are eligible for the fair value option at that date. If the fair value option is elected for any of those securities at the effective date, cumulative unrealized gains and losses at that date shall be included in the cumulative-effect adjustment. The amount of unrealized gains and losses reclassified from accumulated other comprehensive income (for available-for-sale securities) and the amount of unrealized gains and losses that was previously unrecognized (for held-to-maturity securities) shall be separately disclosed.
If a credit union elects the fair value option for a held-to-maturity or available-for-sale security in conjunction with the adoption of this Statement, that security shall be reported as a trading security under Statement 115. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of a credit union to hold other debt securities to maturity in the future.
I know this has all been a lot of FASB accounting double talk. The typical SFAS is always a quick and often permanent cure for insomnia. But, what follows is sure to interest most credit unions.
There is, with the adoption of FAS 159, a hidden but very advantageous accounting opportunity with respect to existing assets and liabilities. The opportunity involves the ability to sell low yielding assets (both loans and investments) and high cost liabilities (borrowings and fixed maturity certificates) – without having to book a loss through the current year’s income statement.
This is huge! If your credit union is struggling with the bottom line, and you are saddled with a bunch of low rate investments and/or loans, some, or all of these can be sold without having to recognize a loss! You can restructure your statement of condition (balance sheet) almost without penalty.
How does this work? Let’s assume you have a $500,000 held to maturity bond on your books with a rate of 3%. The bond does not mature for another two years, but the current FMV is only $420,000. You would like to sell it, but two things are stopping you. 1) it is classified as held to maturity and you can’t sell it without impairing the rest of your held to maturity investments and 2) you don’t want to have to book an $80,000 loss to your already poor earnings. SFAS 159 provides a solution to this problem.
The transitional rules under SFAS 159 allow for the net loss to be accounted for as a change in an accounting principle. This means that the unrealized loss can be charged to beginning undivided earnings as if the loss was incurred in a prior year. (Note, if the investment is classified as available for sale, then that loss is already recorded in equity as part of the routine FAS 115 adjustment.)
Continuing with the assumption the investment is held to maturity, you will, at the SFAS 159 election date, make an accounting entry for the loss as of January 1, 2007. (SFAS 159 requires you to use the FMV as of January 1, 2007 as your initial measurement date.) Assume at January 1st the FMV was $425,000. The accounting entry would be:
DEBIT: Undivided earnings $75,000
CREDIT: Investments $75,000
From this point, because you have elected the fair value option for this investment, it will be carried at FMV on your balance sheet. If you continue to carry this investment, it technically becomes a trading security. This means you have to continue to carry it at market. The subsequent changes in market value are now charged to current earnings. In our example the current FMV is now $420,000, so there would be an adjustment to the carrying value of the investment of $5,000, and a corresponding loss booked to the income statement.
However, the primary purpose for electing the SFAS 159 option was to sell this investment, which can now be done without booking a gain or loss through current earnings (or a small one, since the market values at adoption date was as of January 1). This could be a great opportunity for credit unions to restructure the balance sheet and increase yields, without taking a “hit” to current earnings!
Time is of the essence. If you want to adopt FAS 159 early, then you must do so before April 30, 2007. It is possible you may have to do this before you file your first Call report for 2007, but I have not heard or read anything from NCUA about this.
The transitional rules we described above for existing assets and liabilities are a one time deal. You have to adopt SFAS 159 for existing assets and liabilities now or the opportunity is lost. Any assets and liabilities acquired after the election date can be classified under SFAS 159 as they are acquired.
You must elect the early adoption by April 30, 2007 or the advantageous treatment for existing assets (and perhaps liabilities) will not be available if you wait.
The choice to adopt SFAS 159 early must be made within 120 days of the beginning of January 1, 2007, or April 30th. However, SFAS states that early election by April 30 is available provided the credit union has not yet issued financial statements, including required notes to those financial statements, for any interim period. Now, credit unions do not generally issue interim financial statements complete with footnotes, but it could be interpreted that the election should be made before the Call Report is filed for the first quarter. There is no official word on that, which we know of.
Keep in mind that these rules apply to loans as well. I know of plenty of credit unions with some low yielding fixed rate loans. SFAS 159 may present an opportunity to sell some, or all of those loans without taking a hit to current earnings.
Don’t forget about debt and certificates of deposit. If you have FHLB advances at a high cost but penalties preclude you from paying them off, SFAS 159 may offer a solution. You can mark the debt to FMV and pay it off without having to book the losses from penalties to current earnings, as those penalties would be incorporated into the one time SFAS 159 adjustment to undivided earnings.
Bear in mind this SFAS adjustment is not without its downside. While current 2007 earnings will not be impacted, capital will take a “hit”. This means your capital ratios will go down. You need to have a strong enough capital position to afford the write down. Also, once reclassified under SFAS 159, any assets and liabilities you continue to carry on the books will have to be adjusted to FMV every month. On going changes to these reclassified assets will have to be recorded as gains or losses in the income statement.
I know this is a lot to digest, and you have to act fast if you want to take advantage of the early election, but it may be worth your while to move on this election quickly. It seems to be a terrific opportunity.
Call me if you want to discuss this further.
Bob Anderson, CPA
Some of this material was produced by the Financial Accounting Standards Board and by FTN Financial.