A Chief Financial Officer Perspective: The Current Debate on FAS 115 & EITF No. 03-1

If you hold available-for-sale investment securities – the following update is for you. In March 2004, the Emerging Issues Task Force (EITF) issued No. 03-1 entitled, “The Meaning of Other-Than-Temporary-Impairment and Its Implications to Certain Investments.” The EITF was formed in 1984 to assist the Financial Accounting Standards Board (FASB) with improving financial reporting through timely identification, discussion and resolution of accounting issues. The initial interpretations of how to apply the impairment provisions were very broad. In the strictest interpretation of the rule, if a financial institution sold one available-for-sale security (AFS) at a loss, the remaining AFS portfolio would need to be valued at the lower of cost or market. These market value losses would need to be recorded through the income statement. In other words, a credit union that sold one AFS security at a loss would not only record the realized loss related to that particular security, but would also be required to record an impairment charge for any other AFS securities that were in unrealized loss positions. Until the release of EITF No. 03-01, unrealized losses on the AFS portfolio were recorded through the balance sheet under equity, and did not affect the income statement unless a severe impairment condition existed (i.e., the credit union had reason to believe that it would not receive all of its principal back). Within EITF No. 03-1 all declines in market value below amortized cost are considered “other than temporary” unless the investor has the intent and ability to hold the security “until a forecasted recovery of fair value up to (or beyond) the cost of the investment,” which in certain cases may mean maturity. The Issue continues, “The investor should consider whether its cash or working capital requirements and contractual or regulatory obligations indicate that the investment may need to be sold before the forecasted recovery of fair value occurs.The investor should develop an evidence-based judgment about a forecasted recovery of fair value.” There have been many comments to date on EITF No. 03-1, from accounting firms, credit unions, banks, and brokerages. As a result, the EITF has delayed the effective date of certain sections of the standard that are most controversial. Financial institutions are hoping that the final version of the guidance will limit the scope of impairment to only those instances in which a severe credit event has occurred. Sales for liquidity purposes or sales in which the loss is not significant (i.e., less than 5% of the book value) should not taint the remaining AFS portfolio. The EITF continues to receive comments and has recently indicated an update will be released in early 2005. As I listen and read the discussions on EITF 03-1, I can’t help being reminded of another accounting pronouncement issued about a decade ago. That familiar pronouncement FASB 115, introduced the concepts of “Held-to-Maturity” (HTM) and “Available-for-Sale” (AFS) as designations for investment security holdings. At the time, as a good investment manager and asset/liability practitioner, I couldn’t possibly see FASB 115 becoming a reality. How could the accounting profession allow recognition of changes in the value of assets (investment securities) without looking at the change in value of the liability side of the balance sheet? In a fairly well matched credit union, unrealized gains or losses on investment securities could be substantially offset by changes in the value of liabilities. Much to my surprise, the day ended with FASB 115 implemented and changes in value of AFS securities pushed through equity and a relatively restrictive HTM requirement for maintaining investment securities on an amortized cost basis. EITF 03-1 reflects similar logic, this time using impairment, a concept long used to deal with the collectibility of debts, being applied to market valuation of investment securities. If the market value of the investment decreases by more than 5% it might have to be written down reducing current earnings. If the security is not written down, it would be subject to substantial scrutiny if sold. How will this impact credit unions? EITF 03-1, in its current form, would apply to all investment securities held by credit unions. All Agency issued Callables, Mortgage Backed Securities, and CMOs would be subject to the tests in EITF 03-1. A typical 15 year MBS carries a price sensitivity or duration of about 4-5%. Thus an interest rate increase of just over 1% would move this security into impaired status. Investment securities managers at large organizations are expected to react in a few different ways. First, some will move more securities into the “trading” account designation under FASB 115. This requires constant recognition of changes in market value to the income statement, thus beating EITF 03-1 to the punch. Investment managers may also look to reduce the price sensitivity of their investment holdings to dilute the impact of EITF. Lower duration securities have less of a chance of being categorized as “impaired.” Sophisticated investment managers are expected to use derivative instruments to hedge their EITF exposure by utilizing hedge accounting treatments. For securities held on-balance sheet managers may look to sell and reposition as the market value approaches the 95% threshold. Thirdly, many will look to reduce investment securities holdings by holding loans directly instead of MBS. As mentioned above, we also expect investors to look more closely at instruments not likely to be covered by FASB 115 and EITF 03-1, such as corporate CU certificates and jumbo insured bank CDs. To find out more about EITF 03-1 and its potential impact to your investment security holdings, I encourage you to contact your public accounting firm.