In 2009, the
Financial Accounting Standards Board ("FASB") caved to immense pressure from financial sector lobbyists when it eliminated a requirement that companies disclose market-related losses on asset values. In the furor that followed, scholars and institutional investors pointed out that these changes are likely to set the stage for a repeat of the market catastrophe of 2007-2008. FASB now appears to agree, and is showing the backbone necessary to do something about it.
On May 26, 2010, FASB issued an Exposure Draft of a proposed Accounting Standards Update ("ASU"), Accounting for Financial Instruments, that improves the accounting for financial instruments by updating rules for classifying, measuring and recognizing impairments for financial instruments. The ASU is designed to provide greater transparency in financial statements reporting financial instruments.
Under the proposed accounting standard, almost all financial instruments, including loans, would be reported at fair value. For example, a bank's portfolio of loans previously classified as held-to-maturity or held-for-investment and reported at amortized cost would now be reported at fair value with any fair value adjustments recorded in other comprehensive income on the balance sheet.
Most likely to be affected by the rule change are traditional banks, which have large loan portfolios that under current accounting rules are reported at amortized cost, net of impairments for credit losses. Under the FASB's proposed rule, the traditional banks would value their loan portfolios using fair market value, reporting the loans at amortized cost and fair value on the balance sheet and recording any fair value adjustments in other comprehensive income in the equity section of the balance sheet.
These traditional banks are also likely to be affected by a related proposed amendment concerning the threshold for recognizing credit impairments. Under the proposed guidance, FASB would eliminate the rule that credit impairments need only be recorded when they are probable. The "probable" threshold under current accounting rules results in delayed recognition of credit losses. Instead, the new rule would require banks to record a credit impairment charge in net income when the bank doesn't expect to collect all contractual amounts due under a loan. With a lowered threshold for credit losses, entities will provide more timely information about expected credit losses on financial assets.
In the near term, FASB's Exposure Draft is open to comment from the public. However, if the ASU were to be approved, the financial landscape of banks will forever change. Under the new rules, banks will be required to fair value large portfolios of loans that were once carried at cost on their balance sheets. Further, FASB's proposed amendments will make it difficult for banks to ignore impairments caused by credit losses in loan portfolios. As the financial crisis still shadows the financial markets, the FASB's new push for transparency will be welcomed by many investors.