In the past three years, seven U.S. banks failed. These include Silicon Valley Bank, Signature Bank and First Republic Bank which held $548.5 billion in total assets—about 46 percent more than the combined 25 banks that failed at the start of the 2008 financial crisis.
Some executives as a result are bracing for more bank runs, pointing to troubled commercial mortgages that make up almost a quarter of median U.S. bank’s loan holdings as a potential factor. Others – accounting practitioners – say savvy businesses can successfully navigate this year’s economic stresses.
With inflation still above the Federal Reserve’s comfort level, businesses should keep in mind the many accounting issues that can affect their bottom line, practitioners at Thomson Reuters (TR) told us in May 2023. Many loans, leases, investments, and tangible and intangible assets, for example, are measured based on current or future interest rates, they said.
“A slight pull on any one of many macroeconomic levers could cause interest rates to jump and keep jumping,” Pilar Garcia, TR’s Tax & Accounting executive editor, said. “Although inflation seems to be slowing down, inflation should still be a recurring month-end or quarter-close checklist item,” she said.
“Many line items are sensitive to market prices, interest rates and interest cost because they are key valuation inputs or affect impairment analyses; balance sheet items can spoil quickly in today’s environment no matter how resourceful a company may have been to manage its spending and working capital,” Garcia said. “And while a company may have found a way to manage its risk and exposure to inflation, that may not be the case for some of its business partners or customers and their book of business,” she added. “How might this affect the accounting for multiyear contracts and different product offerings?”
Prior to this year, banks already shifted to tighten lending standards, especially for business and commercial real estate borrowers, which historically happens in the immediate run up to or during recessions, according to Capital Economics’ Q2 US Economic Outlook.
Amid the buzz, businesses should be extra vigilant about accounting rules that address critical assets such as FASB ASC 255, Changing Prices, ASC 326, Credit Losses, and ASC 842, Leases, practitioners said.
ASC 255 provides disclosures for the effects of changing prices, and “it is extremely important for users of the financial statements to be able to understand how inflation affects a reporting entity,” Kara Peterson, TR’s Tax & Accounting senior specialist editor, said. “This includes how downstream impacts (such as actions taken by regulators to combat inflation) influence the entity’s business, results, financial condition, cash flows, risks and uncertainties,” she said.
“For instance, in Q1, we saw the collapse of Silicon Valley Bank. One of the bank’s weaknesses stemmed from the current economic environment,” said Peterson. “Rate hikes imposed by the US Federal Reserve to fight inflation had led to significant declines in the fair values of the bank’s assets (such as held-to-maturity debt securities),” she said. “When the bank needed to sell assets for liquidity, it was unable to generate sufficient funds. Users less familiar with accounting rules may not understand the full effects of inflation just by looking at the numbers recorded in an entity’s financial statements. Therefore, describing the effects in plain language is key.”
In addition to the matters discussed in ASC 255, a reporting entity may identify other impacts of inflation that warrant disclosure, Peterson added. “Even if a particular disclosure is not recommended by ASC 255, a reporting entity should not shy away from providing the disclosure if it would be beneficial to users of the financial statements.”
New Approach for Estimating Credit Losses
ASC 326 is critical this year especially for privately held companies because it introduces the current expected credit losses (CECL) model which requires a timelier report of losses from soured loans.
“For all non-public business entities that will adopt this new guidance, I encourage them to begin looking at the requirements as soon as possible so they allow adequate time to make an accurate implementation,” Mark Wells, TR’s senior executive editor of Tax & Accounting Products, said. “They will need to compare the new approach to estimating credit losses with their existing approach and determine whether any changes are necessary,” he said. “For entities that only have trade accounts receivable that are subject to this new guidance, they will need to use historical experience, current conditions, and reasonable forecasts to estimate credit losses for all outstanding accounts, not just on those accounts that are past due as of the reporting date.”
Similarly, Brett Wemer, TR’s audit content senior editor, stressed that “while it is possible that adoption of the standard will not result in material changes in the measurement of expected credit losses, when compared to the previously measured probable losses, it is not possible to arrive at this conclusion without taking the time and effort to consider the required data inputs to measure the expected credit losses, including the requirement to adjust historical loss data to reflect changes in asset-specific considerations, current conditions, and reasonable forecasts of future economic conditions, which can become more challenging when future economic conditions include greater uncertainty.”
Real Estate Markets Under Stress
ASC 842 was also flagged, not only because private companies are in the early stages of implementation and experiencing some hardships in implementing the standard, but also due to the distress in the real estate market related to the effects of the current economic downturn.
“Both residential and commercial real estate markets have come under stress due to the effects of the pandemic and other economic factors,” Tamara Hubbard, TR’s Tax & Accounting specialist editor, said. “Other entities may have investments in mortgage-backed securities. In commercial real estate, factors such as corporate layoffs, hybrid work environments, pressure to modernize facilities in a tenant’s market, and overleveraged loans have contributed to the highest office vacancy in 30 years as of the end of 2022,” she said.
With the overall downturn in the economy and rising interest rates, this may force some companies to make tough decisions on how they will meet or relieve themselves of loan obligations on their property. “If the commercial real estate industry faces an overall dive, as some analysts predict for later this year, these companies will have to consider negotiating new terms with lenders and tenants, possible foreclosure on their property, attempts to reimagine the property to draw new investors and/or tenants, or sources of new capital,” Hubbard said. “These events have a potential impact on current lease terms and may lead to lease modifications, terminations, and loss of renewals,” she said. “Accounting professionals should ensure they understand the proper application of the guidance under FASB ASC 842 for these changes in their lease population.”
Hubbard suggested that senior financial reporting professionals educate themselves and their senior management on the accounting effects that different strategies to manage the current economic conditions and a possible worsening of the real estate market could have on financial reports and key financial indicators (which could affect loan covenants and other contractual agreements). “They should also consider applying even closer scrutiny of the conditions that may raise substantial doubt about the entity’s ability to continue as a going concern in accordance with FASB ASC 205-40, Going Concern.”
Monitoring Newer FASB Initiatives
Asked which FASB projects they are most interested in, practitioners flagged Proposed Accounting Standards Update (ASU) No. 2023-ED200, Intangibles—Goodwill and Other—Crypto Assets (Subtopic 350-60): Accounting for and Disclosure of Crypto Assets; Proposed ASU No. 2023-ED100, Income Taxes (Topic 740): Improvements to Income Tax Disclosures, plus environmental, social and governance (ESG) related issues.
All three can hold bottom line impacts for companies.
Although still in its early stages, the FASB is working on clarifying reporting rules around environmental credit programs such as renewable energy credits and carbon offset credits.
“As a user of financial statements, it is not always clear to me how companies are accounting for these programs and the related effects on the financial statements,” said Peterson. “For instance, some companies may be accounting for the credits as inventory and others may be accounting for them as indefinite-lived intangible assets,” she said. “However, the income statement effects of these approaches differ. As these credits become more common, having the FASB weigh in can help reduce the diversity in practice from an accounting and disclosure perspective.”
Coming Disclosure Rules on Taxes
In terms of proposed tax rules, the FASB aims to bring more transparency about companies’ exposure to changes in tax legislation and the global tax risk they may face. The public has until May 30 to submit comments.
Practitioners focused on privately held companies are conflicted – in one sense wary of “disclosure overload” but glad about the differentiation the FASB is making between public and private companies.
And two suggestions were made: 1) that the board further clarify ASC 740-10-50-15 which addresses the unrecognized tax benefit related disclosure, so that businesses are clear that the disclosures are not required if an entity has no unrecognized tax benefits; and 2) to revisit ASC 740-10-50-23 for private companies, as they are not exempted from the rule to disclose the amount of income taxes paid to each individual jurisdiction that represents 5 percent or more of the total income taxes paid.
“For some nonpublic business entities that operate in multiple states, this disclosure could become lengthy, and I do not see the benefit this information would provide to the users of the financial statements,” said Wells. “If the information was relevant to the user, they could request it from management because they have direct access to management.”
An Explicit Crypto Standard in GAAP
On crypto assets, the proposal was well received, with many agreeing its timely and needed.
The board proposed that tokens that meet six specific conditions should be measured at fair value and changes in value recognized in each reporting period as profit or loss. Businesses have until June 6 to submit comments.
Under existing U.S. GAAP, crypto assets generally are treated as indefinite-lived intangible assets; declines in the asset’s fair value may result in writing down the asset, but subsequent increases in fair value are not recognized. Thus, given that crypto assets are highly volatile, the changes in fair value can be significant, practitioners said.
“I agree with the FASB’s proposal to subsequently measure crypto assets at fair value with changes recognized in net income,” Peterson said. “It may be difficult to determine the fair value of crypto assets in an inactive market,” she said. “With this in mind, it may be helpful for the FASB’s final standard to include examples of the accounting and disclosure for crypto assets without quoted prices in active markets.”
Additionally, Wemer observed that the general perspective of the broader business community towards cryptocurrencies has likely evolved significantly since initial interest in an accounting topic was created, primarily due to the collapse of FTX and other crypto-related failures, adding that “regardless of this change in perspective, the use of cryptocurrencies remains prevalent and is still an accounting topic worth considering.”
Moreover, Garcia said now that the FASB is addressing digital assets, she is “curious about the Board’s views on other recent technological advancements and the exciting effects on the accounting profession in general (the use of AI in forecasting, for example),” including the costs of that emerging technology and whether they are “wondering if those costs and assets clearly fit (or don’t fit) within the current GAAP framework?”
If finalized, the guidance will be the first explicit cryptocurrency standard in U.S. GAAP.
To get up to speed and prepare for the crypto assets standard, entities can easily review the FASB’s proposal on Checkpoint, Emily Hildebrand, TR’s senior specialist editor, suggested. “Entities can also provide comment to the FASB about the proposal until June 6, 2023, and subscribers to GAAP Reporter can also access expert analysis of the crypto project to date at 350.2 – Client Memorandum – Accounting for Digital Assets,” she said.
This article originally appeared in the May 18, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.
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