Accounting Update Part 4 Chicago Regional Training Conference Indianapolis, Indiana June 14, 2006...

Accounting UpdatePart 4

Chicago Regional Training ConferenceIndianapolis, Indiana

June 14, 2006

Robert F. Storch, Chief AccountantDivision of Supervision and Consumer Protection

Federal Deposit Insurance CorporationWashington, DC

Fair Value OptionFair Value Option

• On 1/25/06, FASB issued a proposed fair value option (FVO) for most financial assets and liabilities

– Would not apply to demand deposits– Exposure draft comment period ended

4/10/06

• Election would be on an instrument-by-instrument basis and irrevocable

• Proposed to be effective for fiscal years beginning after 12/15/06


• FVO-designated financial assets and liabilities will be measured at fair value

– At initial adoption of the standard, the difference between fair value and carrying amount will be recorded through retained earnings

– After adoption, all changes in fair value are recorded through earnings

• FVO election made at inception for each new purchase, origination, or issuance of an eligible financial instrument


• Benefits and objectives of the proposal– Hedge-like accounting without FAS 133 complexity– Eliminate or reduce accounting mismatches– Financial instruments can be managed in

accordance with management's strategy– Further convergence with IASB, which has

incorporated a FVO for financial instruments in IAS 39, Financial Instruments: Recognition and Measurement

– Expanded use of fair value measurement attribute


• Other effects of adopting the Fair Value Option

– FVO requires careful consideration• Election is irrevocable

– Comparison of peers is more difficult• Comparability reduced• Earnings volatility


• Agencies’ 4/14/2006 comment letter to FASB– Concerned about the effect on earnings and equity

of changes in the fair value of financial liabilities attributable to changes in own creditworthiness

• Recommended additional disclosures, including quantitative

• Fair value gains and losses due to creditworthiness are likely to be excluded from regulatory capital

– Concerned about the lack of reliable fair value measurements for non-traded, illiquid financial instruments

FAS 155 on Hybrid Instruments FAS 155 on Hybrid Instruments

• FAS 155, Accounting for Certain Hybrid Financial Instruments, issued February 2006 to amend FAS 133 and FAS 140

• Effective for instruments acquired, issued, or subject to remeasurement in fiscal years beginning after 9/15/06

– Early adoption permitted as of beginning of fiscal year (e.g., 1/1/06) provided no financial statements (including Call Reports) have been issued

• Example of a hybrid is a certificate of deposit whose returned is linked to an equity index


• For a hybrid financial instrument with an embedded derivative that would otherwise require bifurcation and separate accounting for the derivative under FAS 133

– Permits an entity to irrevocably elect to initially and subsequently measure such a hybrid financial instrument in its entirety at fair value, with changes in fair value recognized in earnings

– Option applies on an instrument-by-instrument basis

– In general, an embedded derivative requiring bifurcation is not clearly and closely related economically to the underlying host contract


• Clarifies that only the simplest interest-only and principal-only strips are outside the scope of FAS 133

– To be outside FAS 133, strip should not contain any terms that were not present in the original financial instrument

• Requires a holder of an interest in a securitization to determine if interest is a freestanding derivative or a hybrid financial instrument subject to bifurcation

– Consider payoff structure and payment priority

FAS 156 on Servicing FAS 156 on Servicing

• FAS 156, Accounting for Servicing of Financial Assets, issued in March 2006 to amend FAS 140

• Effective for fiscal years beginning after 9/15/06– Early adoption permitted as of beginning of fiscal

year (e.g., 1/1/06) provided no financial statements (including Call Reports) have been issued

• Requires servicing assets and liabilities to be initially measured at fair value, if practicable

– Changes method of initial measurement for servicing retained when assets are sold from present allocated carrying amount based on relative fair value


• Permits choice of subsequent measurement method for each class of servicing assets and liabilities

– Amortization method – Method currently required with servicing amortized in proportion to and over period of net servicing income/loss with impairment testing based on fair value

– Fair value method – Measure servicing at fair value with changes in fair value reported in current earnings


• Classes of servicing must be identified based on– Availability of market inputs for determining fair

value• OR

– Entity’s method for managing risks of servicing• OR BOTH

• Fair value measurement election for a class of servicing

– Can be made at beginning of any fiscal year– Once made, cannot be reversed


• Upon adoption of FAS 156, AFS securities that had been specifically identified as “hedging” a class of servicing that will be measured at fair value can be reclassified to trading

• Extensive new disclosure requirements, including– Basis for determining classes of servicing– Reconciliation of activity in the balance of each

class– Description of valuation techniques used to

estimate fair value– For amortization method classes, fair value and

reconciliation of activity in any impairment allowance


• Example of accounting for initial measurement of servicing asset at fair value under FAS 156

– Bank A transfers $1 million in mortgages with a 7% interest rate and will continue to service the loans

– Transfer qualifies for sale accounting– Purchaser pays $1 million for the right to receive all

of the principal plus interest of 6%– Seller will receive the remaining 1% interest, of

which 50 b.p. is the contractually specified servicing fee

– Remaining 50 b.p. of the 1% interest is an interest-only strip receivable


Note: Until FAS 156 is adopted, servicing asset is included in the relative fair value allocation

FAS 156 Relative Fair Value Allocation

Fair Value

Percentage of Total Fair

Value

Allocated Carrying Amount

Loans sold $1,000,000 97.09% $ 970,900

I/O Strip $ 30,000 2.91% $ 29,100

Total $1,030,000 100.00% $1,000,000

Pension Accounting ProposalPension Accounting Proposal

• On 3/31/06, FASB issued a proposed new standard, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans

– Applies primarily to pensions and health care plans– First phase of a two phase project to revise or

replace existing standards on these subjects– First phase focuses on balance sheet– Second phase will address recognition and

measurement issues related to changes in fair value of plan assets and benefit obligation

– Exposure draft comment period ended 5/31/06– FASB’s goal is to issue a final standard by 9/30/06


• Objective is to more clearly communicate employers’ postretirement benefit obligations to financial statement users than is done at present through footnote disclosures

• If FASB adopts the proposal as a final standard, it is expected that many employers will report significantly higher liabilities and less equity

– May affect borrowers’ compliance with debt covenants and financial ratios


• Some banks with defined benefit plans have expressed concerns about the effect of the proposal on regulatory capital ratios

• Preliminary analyses of available data for large banking organizations indicate that the effect on these ratios generally does not appear to be material

EITF Life Insurance IssueEITF Life Insurance Issue

• New EITF Issue No. 06-5, "Accounting for Purchases of Life Insurance—Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4"

– To be discussed at 6/15/06 EITF meeting– Under TB 85-4, "the amount that could be realized

under the insurance contract as of the date of the statement of financial position should be reported as an asset"

– Diversity exists in calculating "amount that could be realized."


• Some insurance contracts will pay holder an amount upon surrender that is greater if all individual policies are surrendered at the same time than if surrendered at different times

– Multiple individual policies with a separate rider providing for waiver of surrender charges if all policies are terminated at the same time

– A group life policy with individual coverage on multiple employees that provides an additional value in excess of total amount of individual cash surrender values if group policy is terminated and certain conditions are met


• December 2004 Interagency Statement on the Purchase and Risk Management of Life Insurance addresses the case of multiple individual policies with a separate rider

– Concludes that institution should report each insurance policy on its balance sheet at the policy’s cash surrender value, less any applicable surrender charges, without regard to existence of rider

– Does not address group life insurance policy, but at least one Big 4 accounting firm has applied statement’s guidance on multiple individual polices to group policy


• Two issues EITF is addressing– Whether a policyholder should consider any

additional amounts included in the contractual terms of the insurance policy other than the cash surrender value in determining the "amount that could be realized under the insurance contract“

– Whether a policyholder should consider the contractual ability to surrender all of the individual-life policies (or certificates in a group policy) at the same time in determining the "amount that could be realized under the insurance contract"

Accounting Update Part 4 Chicago Regional Training Conference Indianapolis, Indiana June 14, 2006...

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