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Time to Review Investment Strategies Given Upcoming Changes in Accounting for Equity Securities

It’s finally happened. After years of deliberation, the Financial Accounting Standards Board issued Accounting Standards Update 2016-01 which will have a significant impact on the financial statements of financial institutions that hold equity securities. The Update is effective in calendar 2018 for public companies and calendar 2019 for non-public companies.

What started out as a proposal to have all financial instruments recorded at fair value through the income statement, has concluded generally with only equity securities being treated as such. If you hold equity securities, you should consider how you will handle this change and manage the impact to your financial statements.

How will the financial statements be impacted?

After the initial adoption of the Update, changes in fair values of equity securities will run through the income statement, meaning potentially significant volatility to your earnings.  The extent of volatility will depend on the nature and volume of your equity portfolio and the changes in the equity markets during any particular reporting period.  The good news is that other-than-temporary impairment issues for these equity securities will go away, including the significant judgement and time that management currently may spend analyzing and documenting their decisions.

Investment Strategy Considerations

So you can be thoughtful about your response to this change, we recommend that you consider the following: 

How important is the dividend income to your overall investment and income tax strategies?

If you are considering a reduction or elimination of equity holdings, you will be reducing investments that typically offer a desirable yield, particularly when factoring in the dividends received deduction on the tax-preferred income. What will you do instead?

Do you donate appreciated securities to charitable foundations?

Under existing rules, your charitable donation expense is substantially offset by the related security gain. With the accounting change, you will recognize the charitable donation expense in the income statement, but in many instances the related security gain would have been recognized in earlier reporting periods. This eliminates some currently enjoyed symmetry, however the more significant issue is that all unrealized gains and losses will be recorded in the income statement as they occur.  Be aware that the tax treatment does not change. Accordingly, this charitable donation strategy may still be valuable for tax planning purposes.

How will Management and the Board of your institution manage the fluctuations in the income statement and regulatory capital?

There is a fair amount of concern over how investors and/or depositors will view an institution’s volatility in earnings. The issue is more pronounced in the Northeast where there is a higher number of institutions that maintain equity portfolios. What will your communication plans be with your constituencies?

Additionally, consider regulatory capital impacts as all of the net unrealized gains/losses on equity securities will be recorded in retained earnings and therefore in Tier 1 and total regulatory capital. Different ratio scenarios and how you will respond should be assessed.

If you choose to divest, how will this impact the financial statements?

Management’s decision to divest equity securities prior to the effective date may trigger other-than-temporary impairment considerations for securities in an unrealized loss position. The reporting period that you make that decision, you may have a potential negative impact on your income statement that was not anticipated.

You may feel that adoption is far off but it is in your best interest to consider the impact different strategies may have on your institution. If you decide to divest in whole or in part, you and your Board have the time to make adjustments thoughtfully and take the market fluctuations into account.