It is interesting to look at the impact of a standard after it becomes effective. As a former auditor now devoting my life to teaching all things accounting, I must admit I spend a lot of time worrying about the transition and implementation of a new standard. I often breathe a sigh of relief once implementation is over and then move on to the next new standard. However, understanding the effects of a new standard and interpreting its impact on financial statements only just begins with implementation. Let’s look at the “aftermath” of one new standard, ASC 321, Investments – Equity Securities. This standard was issued as ASU 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities.
As you may recall from one of our previous blog posts , the accounting for equity securities changed dramatically because of the issuance of this new standard. Gone are the trading and available for sale categories for equity securities, along with the requirement to test for impairment, as long as the security has a readily determinable fair value. ASC 321 requires equity securities with readily determinable fair values within its scope to be measured at fair value with changes in fair value recognized in net income. But what about those equity securities that do not have a readily determinable fair value? The accounting has changed for those as well. As long as an entity does not qualify for use of net asset value as a practical expedient, it may elect to utilize a new measurement alternative that allows the investment to be measured at cost minus impairment, if any, plus or minus observable price changes from orderly transactions for the identical or a similar investment of the same issuer. The aforementioned blog post provides a lot more details on the accounting required by ASC 321.
So, is this new accounting “friend or foe”? Let’s look at two examples. Since the guidance in ASC 321 is effective for public business entities in 2018, both companies reflected the impact in their first quarter 2018 filings.
The first example is Berkshire Hathaway. They posted a $1.14 billion first quarter loss, their first since 2009. While Berkshire shows first quarter operating earnings of over $5 billion, this was more than offset by $6.2 billion in losses on equity securities. The problem for Berkshire Hathaway is that they have a substantial portfolio of equity securities with readily determinable fair values. In addition, 68% of the aggregate fair value is concentrated in five companies (American Express, Apple, Bank of America, Coca-Cola, and Wells Fargo). With a substantial, concentrated portfolio, a decline in the fair value of the stock of just one of these companies can have a tremendous impact. Previously Berkshire classified these securities as “available-for-sale” which meant that any unrealized gains or losses were recorded in other comprehensive income. With the adoption of ASC 321, all changes in fair value for equity investments with readily determinable market values are recorded in earnings. Obviously, Warren Buffet is not a fan and would probably say this new standard is a “foe” (for this quarter anyway). He stated that these changes are meaningless in evaluating the company’s economic performance because they are not representative of what’s going on in the business. True, but what if Berkshire had to sell securities? They would then realize the loss, so many believe this new accounting is more reflective of a company’s financial position.
The second example is Alphabet. In stark contrast to Berkshire Hathaway, they posted net income in the first quarter of $9.4 billion. Of this, approximately $3 billion was from gains on equity securities ($2.6 billion in unrealized gains and $0.4 billion in realized gains), and most of that was from gains on holdings in one company, Uber Technologies. Uber is not public and therefore it does not have a readily determinable fair value. However, Alphabet elected the measurement alternative for equity securities without a readily determinable fair value, which means it measures them at cost, minus impairment, plus or minus observable price changes from orderly transactions for the identical or a similar investment of the same issuer. For more information on the measurement alternative, see our blog post on the subject . Previously, Alphabet would have carried these investments at cost, subject to impairment testing. With the election of the measurement alternative, it now reflects observable price changes, which it did in the first quarter for its holdings in Uber. So, for Alphabet, ASC 321 is probably viewed as a “friend” (for now).
What does the FASB think of all of this? The basis of conclusions section in ASU 2016-01 provides all the ups, downs, ins and outs of the creation and deliberation of the new guidance. For me, one sentence stands out: “Fair value measurement has long been highly controversial, and knowledgeable people have different and strongly held views about fair value as the principal or the only measurement attribute for financial instruments.” The bottom line is there will be more volatility with this guidance. Overall though, the FASB feels that this new guidance provides improved and simplified accounting, which was actually the overall goal of the financial instruments project.
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