There is a financial storm developing. One with the capacity to wreak havoc on the income statements of credit unions (and other institutions) all across America.
The Financial Accounting Standards Board, a private, non-profit organization whose primary purpose is to establish and improve generally accepted accounting principles for public and non-public entities within the U.S., is expected to issue a final accounting standard in the coming weeks that will significantly alter how marketable equity securities are classified and measured.
Under the proposed standard, all investments in marketable equity securities will be recorded at fair value through net income. That is to say, price changes in equity securities will be recorded directly in net income. The available for sale classification, where price changes are recorded as unrealized gains/losses in other comprehensive income, would no longer exist for equity securities.
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What's critical to understand about the proposed standard is that the definition of "equity securities" includes common and preferred stock as you might expect, but it also includes all mutual funds (yes, even bond funds) as well as ETFs – securities that have been widely used by credit unions to fund a variety of §701.19(c) programs such as employee benefits pre-funding, charitable donation accounts and executive benefit plans.
Eliminating the ability to record these securities at fair value through other comprehensive income, i.e. unrealized gains and losses, will increase earnings volatility significantly for credit unions who utilize such investments. In fact, it's likely that the use of equity securities in the credit union space will come to an end as a result of this proposed standard. This is particularly significant because securities such as mutual funds and ETFs have been aggressively marketed to credit unions over the years as suitable mechanisms to fund the above mentioned §701.19(c) programs. Now that these securities will no longer be classified as available for sale, credit unions who own these types of investments may want to consider divesting these holdings in favor of other investment options.
To demonstrate why, consider Table 1 and Table 2. Each shows the monthly income stream from a hypothetical $10 million conservative-balanced portfolio invested across mutual funds and ETFs (roughly 75% fixed income, 25% stocks).
Table 1 represents calendar year 2013, a strong year for the equity markets with the S&P 500 gaining north of 28% for the year while the broad bond market declined by about 2%. Table 2 represents calendar year 2008, a bad year for the equity markets with the S&P 500 declining by roughly 43% while the broad bond market gained about 6%.
The AFS column displays the income stream produced using the current AFS classification while the FVTNI column shows what the income experience would have been during those years under the proposed accounting standard.
It's clear that in both years, the income volatility under the proposed FVTNI method is exponentially greater than that of the current AFS classification. It's also clear that the carnage to the income statement in 2008 under the FVTNI method is nothing short of disastrous. Even in 2013, when total income for the year using FVTNI was roughly $63,000 higher than with AFS, the path to produce that income was quite volatile, mainly because under the proposed standard, income from equity securities becomes somewhat of a crap shoot. Investors will be at the mercy of unknown and unpredictable price changes in order to generate income.
Interestingly enough, research conducted at my firm indicated that for the years 2007 through 2014, the FVTNI method actually produced more cumulative income for this hypothetical portfolio than the AFS classification did. Nearly 20% more. But that higher income came with a heavy price in the form of earnings volatility. For example, in spite of markets that have performed extremely well over the past six years, our research indicated that wild swings in monthly income was commonplace when utilizing the proposed FVTNI methodology, with brutishly negative income produced in many of those months. You'd be hard pressed to find anyone who could honestly say that they would have comfortably weathered the earnings volatility presented by the FVTNI model. Likewise, in my 13-plus years working with credit unions, I have yet to meet a credit union executive, board member or auditor who wants to see earnings volatility of any kind, let alone at these levels.
The FASB is aware of the earnings volatility that the proposed standard creates, but has shown little concern over it to this point. The FASB's main goal with the standard is to simplify the classification and measurement of investment securities, and it feels it has accomplished that. At its November 2015 meeting, the FASB concluded the benefits of the new classification and measurement standard outweigh the costs of application and directed its staff to draft a final standard for vote by written ballot. A final standard is expected to be issued by the end of 2015.
Upon ratification, the effective date of the standard will be Dec. 15, 2018 for credit unions. Understanding the effective date of the standard is important to the extent that, as a result of the changes to the accounting for equity securities, credit unions may indeed choose to divest certain investments in favor of other investment options.
In making these decisions, credit unions will want to be certain they are working with a bona fide institutional advisor to ensure they are receiving the highest quality advice and that their portfolios are being optimally positioned leading up to the Dec. 15, 2018 effective date and beyond. I say "bona fide" institutional advisor because the term "institutional" seems to be used quite loosely in the credit union space these days, with far too many investment programs being touted as institutional when in actuality they are not.
A bona fide institutional advisor is one that excels in the areas that matter most to institutional investors – product transparency in terms of risk, audit quality data and reporting available at any time, automated processes as opposed to manual, specialization, and accounting and regulatory expertise. These are but some of the reasons why bona fide institutional advisors have already: Informed their clients about the proposed standard, discussed transition strategies leading up to the effective date and discussed portfolio changes that will be necessary in order to optimize investment performance post-FASB implementation. Bona fide institutional advisors continue to offer highly effective investment solutions in spite of the challenges presented by this accounting change – solutions that allow credit unions to successfully carry on with pre-funding employee benefit expenses, establishing charitable donation accounts and implementing executive benefit plans. It's clear, however, that in this ever changing regulatory environment, credit unions more than ever need the guidance of a bona fide institutional advisor or else run the risk of traversing a very dangerous and slippery slope.
Author's note: The statements in this article are not intended to be a substitute for the potential requirements of the proposed standard or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Tables 1 and 2 are sample illustrations only – any returns shown are not implied or guaranteed.
Matthew Butler is founder and managing principal of Elite Capital Management Group, LLC. He can be reached at 203-699-9662 or [email protected].
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