With the implementation of the Emerging issues task force (EITF) 03-1 (The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments) opening financial institutions to increased earnings volatility, the Financial Accounting Standards Board (FASB) met last Wednesday and decided to delay the implementation of the portion of the guidance relating to the impairment or price declines on debt securities resulting from rising interest rates. Specifically, the board decided to postpone the effective date for the implementation of paragraph 16 of the guidance as it applies to available-for-sale (AFS) debt securities that are underwater solely because of an increase in interest rates.
As a result of the meeting, two proposed FASB Staff Positions (FSP) would be released for comment this week. The first will contain implementation guidance regarding securities falling under paragraph 16 of EITF 03-1. This is subject to a 45-day comment period and would be effective on the last reporting date for reporting periods (depending on each company's year-end) that end after the final FSP is posted on FASB's Web site. The second FSP indefinitely postpones the effective date for guidance in paragraph 16 until the first FSP is finalized. This is subject to a 15-day comment period.
"What the FASB will be asking the industry to comment on is the interpretation and the delay of the implementation of paragraph 16 of EITF 03-1," said Russell Golden, senior technical adviser at FASB. He added that the board might release additional clarifying guidance if there are further questions from market participants.
Analysts had expected this postponement. "As we noted in our report three weeks ago, it was not in the interests of any party involved in this situation to allow the conservative application of the guidance provided by EITF 03-1," said analysts from Merrill Lynch the day before the FASB meeting. "It now appears that FASB will heed the recommendations of much of the banking and insurance industry in recommending a more rational approach to managing an available for sale' securities portfolio."
The firm added that although it is the board that drafts accounting guidance, the Securities and Exchange Commission (SEC) still has primary responsibility with regards to its implementation. The SEC is expected to remain sympathetic to investors though might stay "in the background" to reduce confusion.
In a report released after the meeting, Merrill analysts said they expect the banking and insurance industries to look closely at the two FSPs. "We expect some practitioners will complain that subjectivity of many of the guidelines remain a concern, though we suspect auditor interpretations may not be as severe in the future as in the recent past on this issue given the FASB's clear intent to reduce potential earnings volatility caused by the implementation of EITF 03-1," analysts from Merrill wrote.
Merrill Lynch added that the FASB's intent was to clearly separate the impact of interest rate movement on valuations for securities that are held in "available-for-sale" portfolios from other kinds of potential valuation declines such as those due to credit quality.
Topics discussed in the meeting
The Board said that investors should assert their ability and intent to hold a forecasted recovery on the individual security level in accordance with paragraph 16 of FASB Statement No. 115 entitled Accounting for Certain Investments in Debt and Equity Securities. FASB also looked into the possibility of grouping securities into broad categories such as Treasurys, corporates, or MBS. However, Merrill said that the Board did not adopt more strict guidance so that market participants would "make good judgements" in designating securities.
Additionally, FASB also discussed the "severity" of the impairment. This pertains to whether the level of impairment could be considered temporary, eliminating the need for an assertion that investors would hold an investment until the forecasted recovery. The Board decided that investors should consider the severity of the impairment. If it is minimal, than it could be deemed temporary, in which case the investor does not need to declare his ability and intent to hold an investment.
Merrill said that for the large banks, "intent and ability" to hold a security in its AFS portfolio is "relatively academic" where the magnitude of valuation drops might test an investor's ability, but this might be more of an issue for smaller banks, added analysts.
The discussion centered around what would constitute a minimal impairment or whether this exception should be extended to securities that fall under paragraphs 10 to 15 of EITF 03-1. These include equity securities, cost method investments and debt securities that could be contractually be prepaid or settled without the investor significantly recovering all of its cost. Merrill Lynch said that the Board was hesitant to give an exact percentage decline (for instance 5% of the original cost) or to propose a specific "cumbersome" historical volatility test.
In its commentary, Deloitte & Touche said the FASB will most likely request for comments on the amount of impairment.
Another issue discussed pertains to interest rate impaired securities that are expected to be sold before recovery where investors previously asserted their ability and intent to hold to a forecasted recovery. The Board talked about when this impairment is considered other-than -temporary. The impairment is regarded as temporary when the investor's assertion to hold an investment to a forecasted recovery is changed. FASB also discussed whether such a change of intent does not call into question the investor's intent to hold other securities to recovery. Changes in circumstances do not call into question investors' ability and intent to hold other securities to recovery. Other circumstances that do not call into question the investor's intent are: unexpected and considerable changes in liquidity needs, sudden and significant increases in interest rates (which considerably lengthen the period that a security would need to be held by the investor), and a de minimus volume of sales of securities, explained Deloitte & Touche.
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