FASB issues statements 166 and 167

The FASB recently published Financial Accounting Statements No. 166, Accounting for Transfers of Financial Assets, and No. 167,Amendments to FASB Interpretation No. 46(R), which change the way entities account for securitizations and special-purpose entities. The new standards will impact financial institution balance sheets beginning in 2010. The impact of both new standards has been taken into account by regulators in the recent “stress tests.”

These projects were initiated at the request of investors, the SEC, and The President’s Working Group on Financial Markets. Copies of the new standards are available at theFASB’s website, along with a concise briefing document.

Statement 166 is a revision to Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and will require more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures.

Statement 167 is a revision to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities, and changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance.

Robert Herz, chairman of the FASB, said:

“These changes were proposed and considered to improve existing standards and to address concerns about companies who were stretching the use of off-balance sheet entities to the detriment of investors. The new standards eliminate existing exceptions, strengthen the standards relating to securitizations and special-purpose entities, and enhance disclosure requirements. They’ll provide better transparency for investors about a company’s activities and risks in these areas.”

Both new standards will require a number of new disclosures. Statement 167 will require a company to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A company will be required to disclose how its involvement with a variable interest entity affects the company’s financial statements. Statement 166 enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and a company’s continuing involvement in transferred financial assets.

Both Statements 166 and 167 will be effective at the start of a company’s first fiscal year beginning after November 15, 2009, or January 1, 2010 for companies reporting earnings on a calendar-year basis.

Fair Valuations - can they propel the next bull run

FASB on April 9, laid to rest atleast a controversial subject on marking assets in distressed economic conditions.

The FASB via FSP157-4 issued its position on defining illiquid markets for assets and giving a leeway that the management can rely on their internal valuation models instead of using the external factors.

The rule revision applies to all assets and liabilities within the scope of accounting pronouncements that either require or permit fair value measurements.

The FSP provides that a reporting entity should evaluate a battery of factors to determine whether there has been a significant decrease in the volume and level of activity for the asset or liability when compared with "normal market activity" for the asset or liability. These factors include, but are not limited to, the following: 

• There are few recent transactions;
• Price quotations are not based on current information;
• Price quotations vary substantially either over time or among market makers;
• Indexes that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability;
• There is a significant increase in implied liquidity risk premiums, yields, or performance indicators for observed transactions or quoted prices when compared with the reporting entity's estimate of expected cash flows for the asset or liability;
• There is a wide bid/ask spread;
• There is a significant decline or absence of a market for new issuances for the asset or liability; and
• Little information is released publicly.

This move is a welcome step and will definetly aid a lot of banks in shoring up their balance sheets. No wonder, that post April 9, most of the markets are on a bull run and have started factoring this change in the swing in the balance sheets of various financial institutions.

The FASB must also be appreciated for relenting under pressure to delineate mark-market to accounting forever and has come out with the correct decision considering the economic scenario.

Will wait and wonder what will be FASB's position in a reverse scenario, when markets are in prime bull position and prices are overvalued, will they come out with a new FSP to FAS 157....????

Read all our earlier articles on Fair value accounting

Bond conversions now weigh on your EPS

With the change of an old accounting rule of APB 14-1 "Accounting for Convertible Debt Instruments That May Be Settled in Cash Upon Conversion" coming into effect this quarter, companies may start seeing a dip in the EPS reported. The rule which was amended last year, requires companies which settle their bonds (liabilities) in the form of part equity and part cash, now will have to take an additional charge to the income statement on account of interest expense, thereby lowering the EPS

The interest expense will be the differential between the value of the equity shares as on the date of the conversion and the maturity value of the debt.

This rule does not affect straight convertible debt that must be settled with the corporate issuer's stock, convertible preferred shares classified as equity, convertible debt with embedded options that are recorded as derivatives, and convertible bonds that require cash settlement for fractional shares when converted.

Separating the settlement into cash and shares requires the use of so-called split accounting to record the transaction. That is, the issuer must book the debt and equity components of the bond separately. It's the split that results in a higher interest expense on the income statement that tugs the EPS ratio down. Here's why.

A convertible bond is attractive to issuers because the interest paid to bondholders is lower than the market rate for most other borrowing. On the other hand, the low-interest bond attracts investors because of the conversion option, which allows the bondholder to turn the debt into equity if market conditions are favorable. For many, convertible bonds were seen as a win-win situation.

But FASB wanted to make sure that companies issuing convertible debt reflected the economic reality of the instrument — that is, the risk associated with the bond — on their financial statements. In the board's opinion, companies that issued convertible bonds had a tendency to inflate their EPS because the interest expense associated with the potential cash payout was under-reported.

The new rule, however, forces companies to record a higher interest expense — or a higher depreciation expense in the case of debt used for capital improvements — because the debt is calculated as if there were no conversion option, and will be settled in cash. That assumed cash payout includes the additional interest expense.

FASB also is requiring that the rule be applied retrospectively to 2008 financial statements. That means that if issuing companies report a material adjustment to their income statement, they must restate their financial results accordingly, going back two or three years, depending on how many years of comparison reporting they included in their 2008 filings.