Recent communications by the Federal Reserve Board Federal Open Market Committee (FOMC) have set the stage for increases in interest rates in mid to late 2015. As the domestic economy continues to demonstrate fundamental signs of a sustained recovery, including modest price increases and wage gains, few have challenged the merit of increasing interest rates in the near term. Notwithstanding relatively universal agreement on the merits of increasing interest rates, financial services companies have been presented with challenges arising from the application of an accounting standard (ASC 320, Investments — Debt and Equity Securities) not effectively aligned with the current economic environment, nor the needs of the users of their financial statements.
ASC 320 – classification of investments in debt and equity securities
Specifically, ASC 320 codifies the accounting standards, established in 1993, for debt and equity securities. Most notably, this accounting guidance requires companies to classify investments in debt and equity securities as either held to maturity (HTM), available for sale (AFS), or trading. The recognition of changes in the underlying fair value of these securities is significantly different depending upon that classification. Also, the consequences of executing transactions, internally or externally, which are not consistent with these classifications may be significant to how securities are accounted for subsequent to those transactions.
Changing financial environment causes accounting risks
During the recent financial crisis most banks shifted a significant portion of their assets to higher quality debt securities, including US Treasury and agency securities, mostly because of lack of clarity of emerging capital standards (Basel III) and significant reduction in loan demand. This shift resulted in a heightened exposure to interest rate risk as well as adjustments to the fair value of these securities, mostly those classified as AFS and trading. In anticipation of increases in interest rates, larger banks with less accommodative capital standards related to changes in fair value of securities have begun to revise the classification of AFS securities to HTM (which are less affected by a rising rate environment from an accounting perspective). These changes in classification, although allowable within the accounting standards, appear to be influenced far more by those standards than by the business objectives of the company or the objectives of the financial statement users.
Necessary change on the horizon
In 2013, the Financial Accounting Standards Board (FASB) released for comment a proposed standard Accounting for Financial Instruments: Classification and Measurement. This proposed standard much more effectively aligns the accounting applications for measurement and classification of financial instruments, including debt and equity securities, with current dynamics related to fiscal policy, regulatory capital standards, and the relevant objectives of users of financial statements.
Currently, FASB anticipates a Q2 2015 release date of this standard. As of now, the proposed standard does not include a definitive effective date. Recent actions by major US banks to modify the classification of their investment securities strongly argue for timely effectiveness of this standard, including the ability to elect to apply these revisions in the current year.
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