Remarks before the 2016 AICPA National Conference on Current SEC and PCAOB Developments
Brian Staniszewski, Professional Accounting Fellow, Office of the Chief Accountant
Dec. 5, 2016
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Good morning. Today, I would like to discuss the FASB’s updated recognition and measurement guidance for financial instruments, and then share some observations on recent accounting consultations.
New Financial Instruments: Recognition & Measurement Standard
Let’s start with the updated recognition and measurement guidance for financial assets and financial liabilities. In January 2016, the FASB issued ASU 2016-01 to enhance certain aspects of the recognition, measurement, presentation and disclosure requirements for financial instruments.
One aspect of this new guidance that I would like to discuss focuses on the new presentation requirements for financial liabilities for which a fair value option has been elected. Prior to adopting this new guidance, an entity that elected the fair value option for an eligible financial liability would present the total change in the financial liability’s fair value in earnings. ASU 2016-01 amended Topic 825 to address concerns that entities would report gains (or losses) in earnings due to a change in a financial liability’s fair value resulting from an increase (or decrease) in an entity’s credit risk. The updated guidance requires entities to present separately, in other comprehensive income (OCI), the portion of the total change in a financial liability’s fair value that results from a change in instrument-specific credit risk.
To be clear, the guidance is not changing how an entity determines the fair value of a financial liability. That will remain the same. However, for financial liabilities within the scope of this new guidance, the total amount of gains or losses previously reported in earnings may change, as a portion of the total change in a financial liability’s fair value may need to be separately presented in OCI.
I would like to share some observations today regarding implementation of the new guidance as it relates to measuring instrument-specific credit risk in financial liabilities.
Hybrid Financial Liabilities
The first observation relates to a scoping question for hybrid financial liabilities. An example of a hybrid financial liability would be a debt obligation that is indexed to the price of gold and requires cash settlement. Assume, for purposes of this example, that the feature indexed to the price of gold would be considered an embedded derivative requiring separate accounting. Instead of separately accounting for the embedded derivative, the derivatives guidance provides an irrevocable election to initially and subsequently measure the hybrid financial liability, in its entirety, at fair value with changes in fair value reported in earnings. The scoping question is whether an entity that elects a fair value option under the derivatives guidance should separately present in OCI the portion of the total change in the hybrid financial liability’s fair value due to a change in instrument-specific credit risk.
Let me shed some light on how I have thought about this question. There is no requirement to first evaluate whether an entity can elect a fair value option under the derivatives guidance in Topic 815, prior to electing a fair value option under Topic 825. GAAP does not prescribe a sequence that must be followed. Therefore, I see no conceptual basis to exclude a hybrid financial liability, solely based on how an entity documents its fair value option election, from the new presentation requirements regarding changes in instrument-specific credit risk. Accordingly, I believe an entity that elects a fair value option under either guidance for an eligible hybrid financial liability should present separately in OCI the portion of the total change in fair value that results from a change in instrument-specific credit risk.
Instrument-specific credit risk
The second observation relates to the measurement of instrument-specific credit risk. Here, the updated guidance states that an entity may consider the portion of the total change in fair value that excludes the amount resulting from a change in a base market risk, such as a risk-free rate or a benchmark interest rate, to be the result of a change in instrument-specific credit risk. I’ll refer to this as the “base rate method.” An alternative method, however, may be used if it is considered to faithfully represent the portion of the total change in fair value resulting from a change in instrument-specific credit risk.
Let me highlight two scenarios to provide some perspective on how I have thought about the measurement of instrument-specific credit risk for certain types of financial liabilities in which a fair value option has been elected.
Under the first scenario, consider a financial liability for which the payment is solely tied to the value or cash flows of an asset pledged as collateral. That is, there is no recourse to the debtor. The risk of nonpayment, and the corresponding changes in the financial liability’s fair value, will be directly impacted by the risk that the underlying asset will perform poorly (or not at all). In this fact pattern, I believe that no portion of the total change in the financial liability’s fair value would be attributable to instrument-specific credit risk. Instead, the financial liability’s fair value will be solely tied to the risks inherent in the specific asset pledged as collateral. Therefore, I would expect all changes in the financial liability’s fair value to be reported in earnings.
Under the second scenario, consider my earlier example of a hybrid financial liability that consists of a debt obligation that is indexed to the price of gold and requires cash settlement. The fair value of the hybrid financial liability will be impacted, in part, by the price of gold. In this circumstance, I do not believe application of the base rate method will faithfully represent the portion of the total change in fair value resulting from instrument-specific credit risk. The takeaway in this scenario is that application of the base rate method may not be appropriate in all circumstances. As the terms of a financial liability become more complex, more judgment is needed to determine if an alternative method is required.
Income Tax Accounting
Next, I would like to share some observations on income tax accounting.
OCA continues to consult with staff in the Division of Corporation Finance in evaluating certain judgments companies have applied in accounting for income taxes. One recent area of consultation relates to the recognition of deferred taxes on undistributed earnings of a foreign subsidiary. The income tax accounting guidance creates a presumption that undistributed earnings of a subsidiary will be transferred to the parent entity, resulting in the parent entity accruing taxes on the undistributed earnings. However, that presumption can be overcome, and no income taxes would be accrued by the parent entity, if certain criteria are met. This continues to be an area involving a significant amount of judgment. We have questioned registrants in situations where disclosures made outside of the audited financial statements call into question (or potentially contradict) assumptions relied upon in accounting for undistributed earnings under Topic 740.
One takeaway is that the judgments applied in accounting for income taxes may require coordination among multiple business functions within a company’s global organization, including accounting, treasury, and other business functions.
The last topic I would like to address relates to financial instruments that have characteristics of debt and equity.
OCA has observed several fact patterns in which registrants have not complied with the debt-equity guidance. A recent fact pattern involved a registrant that issued warrants on its common stock. The warrants included a “put” feature allowing the warrant holder to sell the warrants back to the registrant for cash equal to the fair value of the warrants. OCA objected to equity classification of the warrants, as the registrant may be required to transfer cash to settle the warrants. In this case, the warrants would be classified as a liability under Topic 480. This fact pattern, along with other areas we have evaluated over the past year, highlights some of the difficulty we have observed in navigating through the debt-equity guidance.
I would highlight that companies, including management and Audit Committees, need to continually assess whether they have resources with sufficient training available to support high quality financial reporting. This is fundamental to the effectiveness of a company’s overall control environment. Finally, consultation with OCA is available when evaluating the accounting for highly complex or structured capital raising transactions.
Thank you for your kind attention.
 Accounting Standards Update No. 2016-01, Financial Instruments — Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.
 Pursuant to ASC 825-10-65-2(c), entities may early adopt the new presentation guidance requiring entities to separately present in OCI the portion of the total change in a financial liability’s fair value that results from a change in instrument-specific credit risk. Otherwise, the guidance is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017.
 See ASC 825-10-45-5.
 See ASC 815-15-25-1.
 See ASC 815-15-25-4.
 See ASC 825-10-45-5.
 Office of the Chief Accountant.
 See ASC 740-30-25-3.
 Pursuant to ASC 740-30-25-17, a parent entity shall have evidence of specific plans for reinvestment of undistributed earnings of a subsidiary which demonstrate that remittance of the earnings will be postponed indefinitely.
 For example, disclosures made within Management’s Discussion and Analysis, pursuant to Item 303 of Regulation S-K.
 See ASC 480-10-25-8.
 Guidance for consulting with OCA is available at: https://www.sec.gov/info/accountants/ocasubguidance.htm