FASB #2

Introduction

This report is meant to assist Cherryfarm Anomaly Bancorp, Inc. (CAB) in transitioning to the new accounting rules under SFAS 159: The Fair Value Option for Financial Assets and Financial Liabilities (Including an amendment of FASB Statement No. 115).  SFAS 159 allows entities to report many financial instruments such as investments in securities at fair market value.  It is intended to help reduce volatility in earnings by measuring related assets and liabilities using the fair value option.     

Available-For-Sale and Held-To-Maturity Treatment

If you choose to elect the fair value option under SFAS 159 for some but not all of CAB’s securities (including available-for-sale and held-to-maturity), the corresponding securities should be reported as trading securities under SFAS 115 and reclassified to their fair values on the balance sheet at the effective statement date (SFAS 159, ¶ 29).   However, you must report the current cumulative unrealized gains and losses from those securities as a component of the cumulative-effect adjustment to the opening balance of retained earnings.  To accomplish this for the available-for-sale securities, the unrealized gains and should be reclassified from accumulated other comprehensive income and closed to retained earnings on the balance sheet.  For the held-to-maturity securities, you must report the unrealized gains and losses that were previously unrecognized into retained earnings.  In addition, both of the available-for-sale and held-to-maturity adjustments are required to be disclosed separately (SFAS 159, ¶ 28).  Since the gains and losses are not reflected in the income statement at the effective date, there will be no direct effect on net income, therefore reducing its volatility.  However, changes to fair value after this date will be a component of earnings displayed in the income statement.   For the securities that you choose not to elect the fair value option, you may continue to present them in the financial statements as they have been previously reported. 

If you decide to elect the fair value option for some but not all of your securities, you will have to prepare a disclosure for this election to fulfill the disclosure requirements. The disclosure requires explanations of management’s reasons for not electing the fair value option for all available-for-sale and held-to-maturity securities.  In this disclosure, you must describe the securities—including the amount of the corresponding retained earnings adjustments—and then give reasons why CAB is choosing to use the partial election (SFAS 159, ¶ 18, 27).  CAB also has to provide enough information to enable users of the financial statement to understand how the securities relate to individual line items on the statement of financial position (SFAS 159, ¶ 18, 27).

Rules Related to Transition

When CAB adopts FAS 159, there are some rules related to the transition that should be understood.  The retrospective application of the fair value option to fiscal years before the effective date is not permitted, which means that you should not restate prior-period financial statements.  As previously mentioned, a cumulative-effect adjustment of retained earnings is to be performed at the effective date when applying the fair value option to CAB’s available-for-sale and held-to-maturity securities.  Thus, the unrealized gains and losses from previous years are reflected in retained earnings, making it unnecessary to restate prior-year financial statements (SFAS 159, ¶ 46). 

Investment in Offbeat Green Energy, Inc. (OGE)

According to SFAS 159, you cannot selectively elect the fair value option for CAB’s equity investment in OGE but not the loan to OGE. SFAS 159 states that if the fair value option is applied to the investment under the equity method of accounting, then the fair value option should also be applied to any financial interests in the same entity, including debt. Since the equity investment in OGE and loan to OGE are considered financial interests in the same entity, CAB must elect the fair value option for both the equity and the loan if it wishes to report either of these instruments at fair value.

 
Early Adoption and Suggestions

The effective date of SFAS 159 is at the beginning of the fiscal year that begins after November 15, 2007.  Early adoption of the statement requires that a choice to adopt the statement early be made within 120 days of the beginning of the fiscal year of adoption.  Since it is already the third quarter of fiscal year 2007, you will not be able to adopt the statement until the beginning of fiscal year 2008 (SFAS 159, ¶ 30).  To ensure a smooth year end closing and subsequent audit, it would be wise to disclose CAB’s plans to adopt the statement for the fiscal year 2008 in the footnotes.  This should include the fair market value amounts of all securities for which CAB is going to apply the fair value option, as well as any unrealized gains or losses for held-to-maturity securities. 

Conclusion

When CAB adopts SFAS 159, the goal for fiscal year should be to mitigate volatility in earnings.   Careful analysis of how the reclassification of selected available-for-sale and held-to-maturity securities will affect overall net income and retained earnings should be conducted and taken into consideration before application of the fair value option.  By following the rules related to transition and sufficient preparation to ensure a smooth 2007 year end closing, CAB will be able to successfully adopt SFAS 159 at the beginning of the 2008 fiscal year.