What captive managers need to know, and do, now
The Financial Accounting Standards Board’s (FASB) ASU 2016-01 will have some major implications for those investing in securities with readily determinable values, and with unrealised gains and losses. One will be that the unrealised gain and loss, along with the deferred tax component, will be on the statement of income, rather than the statement of other comprehensive income. There are a few other aspects, but I suspect this will have an impact on almost every captive insurance company.
ASU 2016-1 requires an entity to:
(i) Measure equity investments at fair value through net income, with certain exceptions;
(ii) Present in the other comprehensive income (OCI) the changes in instrument-specific credit risk for financial liabilities measured using the fair value option;
(iii) Present financial assets and financial liabilities by measurement category and form of financial asset;
(iv) Calculate the fair value of financial instruments for disclosure purposes based on an exit price; and
(v) Assess a valuation allowance on deferred tax assets related to unrealised losses of available for sale debt securities in combination with other deferred tax assets.
There is an election to measure certain nonmarketable equity investments at cost less any impairment and adjusted for certain observable price changes. This could be impactful for captives which invest in alternative investments such as partial interest in real estate holding companies.
What is an example of a primary impact?
The explanation sounds like a bunch of accounting gibberish, so let’s talk about how it will impact a captive manager, and then get into some other details. In order to do that let’s provide an example and compare the differences, and examine what must be done as of January 1, 2019, assuming a single year financial statement is being presented, in a simple scenario with an equity security.
A captive invested in Hippopotamus Rental Company (HPC) in January 2018, a company publicly traded on the NASDAQ with a readily determinable value (we will talk about securities without a readily determinable value later). The original investment amount was $100,000. The demand for Hippo rentals has significantly increased and the stock price doubled by December 31, 2018.
Here is how we would record the change in value before ASU 2016-1:
- Debit HPC investment by $100,000 for the change in value (balance sheet account);
- Credit other comprehensive income by $100,000 (statement of other comprehensive income account);
- Credit deferred tax liability for 21 percent (corporate tax rate) times $100,000 = $21,000 (balance sheet account); and
- Debit other comprehensive income for $21,000 (statement of other comprehensive income account).
Here is how we would record the change after ASU 2016-1:
- Debit HPC investment by $100,000 for the change in value;
- Credit change in unrealised gains and losses by $100,000 (statement of income account);
- Debit deferred tax expense by $21,000 (same calculation as before, statement of income account); and
- Credit deferred tax liability by $21,000 (balance sheet account).
The basic premise behind this example is that the effects of the change in value of HPC is now presented on the statement of income, therefore changes in unrealised gains and losses of HPC are a component of net income. In this instance net income would be increased by $100,000.
This is simple. However, not only is this accounting treatment on a prospective basis, we must also reclassify the historical gains and losses.
Many times you don’t hear the word practicality in accounting updates. However, ASU 2016-1 has a specific practicality provision for equity securities without a readily determinable value.
Before ASU 2016-1 other comprehensive income was closed out to accumulated other comprehensive income, a balance sheet account in the equity section of the balance sheet. Historical unrealised gains and losses with the tax effect would be sitting on our balance sheet, so we need to correct the balance sheet as of January 1, 2019, assuming a single year financial statement is being presented.
What would we do using the same example above?
- Debit accumulated other comprehensive income by $100,000-$21,000=$79,000
- This is the unrealised gain of HPC net of taxes; and
- Credit retained earnings for $79,000
The impact here is the impact of unrealised gains and losses for changes in value of readily determinable values are now a component of net income.
What about equity securities without a readily determinable value?
Many times you don’t hear the word “practicality” in accounting updates. However, ASU 2016-1 has a specific practicality provision for equity securities without a readily determinable value. There are some rules you must comply with but it does create simplicity.
Let’s be practical: you can elect on a security-by-security basis to account for the equity security at cost minus impairment. Prior to ASU 2016-1 you could possibly have been forced to get a valuation done of a Level 3 security in order to mark it to fair value. It would have been much more practical to use the cost minus impairment approach. For securities where the practical election is made, a qualitative assessment must be done at the end of each reporting period to determine whether an impairment is required.
Deferred tax assets
The update clarifies that an entity should assess the need for a valuation allowance on a deferred tax asset related to unrealised losses of investments in debt instruments recognised in OCI in combination with the entity’s other deferred tax assets.
Prior to this update, the alternative approach used in practice evaluated the need for a valuation allowance for a deferred tax asset related to unrealised losses on debt instruments recognised in other comprehensive income separately from other deferred tax assets.
This alternative approach will no longer be acceptable. What this really means is that the deferred tax components of investments may now be lumped in with other deferred tax items on the face of the balance sheet and statement of income.
Although other aspects of ASU 2016-1 may be applicable, this article is meant only to give some major points. In order to ensure that you do not have issues on your audit for 2019, I suggest taking a proactive approach and initiating a project to start changing the accounting treatment retroactively and training your accountants on the standard.
Leon Rives is managing partner at Rives and Associates. He can be contacted at: firstname.lastname@example.org