Upcoming Changes to Equity Investments (ASU 2016-01)

The year is quickly nearing an end, which will bring a new set of pronouncements that will become effective in 2018. One of those pronouncements is Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2016-01: Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities.

The main impact of ASU 2016-01 is that changes in the value of equity investments must now be included in net income. Companies will no longer be able to classify an equity investment as available-for-sale and recognize changes in value within other comprehensive income. As a result, companies with significant portfolios of equity investments will likely see increased income statement volatility.

In addition to the above change related to equity investments with readily determinable fair values, there was a change for equity investments without readily determinable fair values. For these investments, ASU 2016-01 eliminated the cost method and replaced it with a practicability exception to alleviate the need for companies to determine fair value at each reporting period.

The practicability exception requires these investments to be measured at cost, less impairment, plus or minus observable price changes (in orderly transactions, which is specifically defined in the ASU as not a forced transaction) of an identical or similar investment of the same issuer, assuming they do not already qualify for the net asset value per share practical expedient. Similar to the above, all changes are included in net income.

The implementation guidance issued with ASU 2016-01 indicates that companies do not have to perform an exhaustive search for observable price changes but it will require some effort to identify known or reasonably knowable transactions. Companies should carefully consider the selection of this exception, which the standard permits on an investment-by-investment basis.

This ASU also simplified the impairment method for these investments. As a result, readers of financial statements should see more frequent remeasurement of these investments to fair value.

Two other key changes that came from ASU 2016-01 relate to financial liabilities and deferred taxes. To the extent that a company elects the fair value option for financial liabilities, changes in value related to instrument-specific credit risk will flow through other comprehensive income. As such, a company’s credit risk will not affect net income. As it relates to deferred taxes, the FASB clarified that companies should assess the need for a valuation allowance on deferred tax assets related to available-for-sale debt securities in combination with other deferred tax assets. This clarification should eliminate diversity in practice, since some companies currently assess the need on a separate basis.

ASU 2016-01 is effective for public companies in periods beginning after December 15, 2017 and for all other companies in periods beginning after December 15, 2018. Companies that are not public may early adopt the ASU in periods beginning after December 15, 2017. All companies may already early adopt certain provisions, specifically those related to financial liabilities. Generally, companies should apply the amendments through a cumulative effect adjustment to the balance sheet as of the beginning of the effective period. The provisions related to equity securities without readily determinable fair values require prospective treatment.

We would be pleased to provide further information related to this subject. For more information, contact Craig B. Evans, Director, Audit & Accounting at cevans@kmco.com

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