August 27, 2018

Peeling Back the “Last-of-Layer” Method: Uncovering Which Prepayable Instruments Qualify

As is often the case with many Accounting Standards Updates (ASUs), the Financial Accounting Standards Board (FASB) has issued interpretive guidance to address technical questions related to ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, in order to “peel back” the last-of-layer method to expose easily overlooked information that could have huge implications for entities with “held-to-maturity” (HTM) debt securities.

What is the last-of-layer method?

According to the update, the last-of-layer method allows an entity to fair value hedge any asset (or portfolio of similar assets) by using the last dollar amount within that portfolio of “prepayable” assets as the hedged item.  Further, when measuring those assets, the entity accounting for them does not need to consider prepayment risk or credit losses.  This method simplifies the hedging process as entities shift focus to determine whether or not a specified asset, or portfolio of assets, qualifies for the last-of-layer method.

Which instruments qualify for the last-of-layer method?

Entities can decide if securities qualify for the last-of-layer method by determining if those securities are considered prepayable.  Some examples of financial instruments that qualify as prepayable under this method are:

  • Non-contingent instruments: This includes debt instruments, such as mortgage loans, that do not include a prepayment clause and are prepayable at any given time.

 

  • Instruments with time-based contingencies: These instruments, such as callable and puttable debt, become prepayable based on time.  As long as they could be prepayable at some point during the hedging relationship, they are considered prepayable instruments under the last-of-layer method.

 

  • Instruments with event-based contingencies: These instruments become prepayable due to the occurrence of a specified event.  For example, instruments that become prepayable due to changes in the tax law would qualify for the last-of-layer method, as the event could reasonably occur at any given point during the hedging relationship.

 

  • Instruments with interest-rate related contingencies: These instruments become prepayable and eligible for the last-of-layer method when a specified interest rate is changed.  Since the timing of the change in the benchmarked interest rate is unknown, the instrument could become prepayable at any moment during its life.

 

  • Instruments with convertible debt: Both callable and non-callable convertible instruments will qualify under the last-of-layer method as long as the conversion of the instruments is contractually permitted at some point during the hedging period.

 

What are the implications?

Once entities have identified debt securities as being prepayable under the last-of-layer method, they will have the one-time option to reclass qualifying HTM instruments to “available-for-sale” (AFS) instruments without tainting their intentions to hold future debt securities to maturity.  The option to reclass is available only at the time of adoption of ASU 2017-12.  The entity is not required to designate the debt security as a hedging relationship; the security simply must be eligible for designation as a hedged item under the last-of-layer method.  Many securities that are classified as HTM will now have a clear path for reclassification as AFS.  The AFS designation requires the security to be reported at fair value and allows it to be sold without justification.  Any unrealized gain or loss at the time of the transfer is to be recognized in accumulated other comprehensive income.

When is the effective date?

For public business entities, ASU 2017-12 is effective for fiscal years beginning after December 15, 2018. For all other entities, the effective date is for fiscal years beginning after December 15, 2019.  Early adoption is permitted.

 

Because of the technical nature of ASU 2017-12, it’s important to review the latest FASB guidance to ensure you understand the impact on your business.  PYA can assist you with any remaining questions you may have about the last-of-layer method and reclassifying debt securities from HTM to AFS.  Or, if you would like to request a speaker on this topic for your organization or event, contact one of our PYA executives below at (800) 270-9629.

 

© 2018 PYA

No portion of this article may be used or duplicated by any person or entity for any purpose without the express written permission of PYA.

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