Accounting standard setters have decided to delay the effective date of and provide further implementation guidance for a rule that would require financial institutions to recognize unrealized losses of debt investments from rising interest rates as a hit to earnings.
Last Wednesday, the Financial Accounting Standards Board (FASB), responding to numerous complaints from the banking sector, stated plans to issue new guidance this week that will specifically address concerns raised from EITF Issue No. 03-1, meant to clarify when impairment of interest-sensitive debt securities held in an “available for sale” portfolio should be recorded on the income statement.
Banks, insurers, and mortgage-financing company Freddie Mac have all criticized Issue 03-1 and pushed FASB to revisit the issue. “The concern was the original version was quite vague on some fairly important issues related to how often an investor could potentially sell a security that is [impaired],” explains Matt Burnell, director of fixed income credit research at Merrill Lynch.
An impairment of a security occurs when the fair value drops below its cost. If a debt security is deemed impaired as a result of an interest rate drop, a financial institution must record that loss in income, unless it states an “intent and ability” to hold the security until the value recovers to par or it matures, in which case, the losses are held in shareholder’s equity on the balance sheet.
The lack of specific guidance reportedly led some major accounting firms to strict interpretations of a line in the rule that sales of interest-rate-impaired securities should factor into an assertion of an intent to hold other impaired securities. The conservative interpretation was that any one sale would taint the assertion for other investments in the portfolio, leading to a potential write-down of all losses of interest-rate impaired securities to flow through income.
The threat of potentially huge earnings volatility as a result “scares the living daylights out of the financial institutions,” says Burnell. He also notes that current expectations that interest rates will rise and cut the value of such debt securities increases the concern for impairment.
To mitigate such interpretations, FASB decided in its Wednesday meeting to propose, among other things, guidance that would clarify that the impairment of debt securities would be considered on a security-by-security basis.
FASB’s staff proposal is also expected to address critics questions over severity of impairments, another issue left out of the initial Issue 03-1 guidance. FASB plans to propose that an impairment that is deemed “minor” or “insignificant,” as a result of lower interest rates, would be deemed temporary and not necessitate a write-down to earnings.
As part of its comment period, the proposal is also expected to see whether a more specific numerical threshold, such as a loss up to 5 percent of fair value, would be a preferable alternative to verbal guidelines.
The reasoning behind the safe harbor for minor or insignificant impairment of debt securities, says FASB board member G. Michael Crooch, is that if the impairment bounces around in a small range because of interest-rate fluctuations, “then you shouldn’t have to make the assertion because [the value] has a good probability of bouncing back.”
Burnell observes that most FASB board members are against issuing such specific numerical guidelines and without it, the guidance could still be considered “relatively vague.” He also notes that some institutions may prefer a more specific number that would ensure that the sale of a certain number of impaired debt securities would not indicate a pattern had formed in the sale of other assets of the portfolio.
Most calendar year companies would have had to comply with the initial 03-1 ruling for treating the impairment of interest-sensitive debt securities in the third quarter, but FASB now intends to issue its final proposal in the fourth quarter, which would put the effective date at year-end.