ASU 2016-01: Equity Securities, Measurement Alternative, and Disclosures

Accounting Standards Update 2016-01, issued by the Financial Accounting Standards Board in January 2016, rewrote how U.S. GAAP recognizes and measures financial assets and liabilities. Codified mainly in ASC Topic 321 and Subtopic 825-10, it eliminated the trading and available-for-sale categories for equity securities, put most equity investments on a single fair-value-through-net-income model, moved the own-credit-risk portion of fair-value-option liabilities to other comprehensive income, and created a cost-based measurement alternative for equity securities without a readily determinable fair value.¹

The New Model for Equity Securities

Under FASB Statement No. 115, entities classified equity securities as either trading or available-for-sale. Trading securities ran through net income. Available-for-sale securities parked their unrealized gains and losses in other comprehensive income, keeping them off the income statement.²

ASU 2016-01 collapses those categories. Virtually all equity securities are now measured at fair value each reporting period, with the change recognized in net income.¹ A publicly traded stock that rises $2 million in a quarter adds $2 million to earnings, sale or no sale. An unrealized drop hits the bottom line the same way. For entities holding large equity portfolios, this can produce meaningful earnings volatility that did not appear before.

For publicly traded securities, fair value typically relies on unadjusted quoted prices in active markets. Entities update those measurements at each reporting date.

What Falls Outside the Model

Several types of investments are excluded from the fair-value-through-net-income model, even though they may look like equity holdings:¹

Investments that result in consolidation of a subsidiary or are accounted for under the equity method.
Industry-specific holdings by investment companies (ASC 946), brokers and dealers in securities (ASC 940), and defined benefit pension and other postretirement plans (ASC 960, 962, 965), which retain their specialized accounting.
Derivatives subject to ASC 815, including options, forwards, and embedded derivatives, even when the underlying is an equity security.
Federal Home Loan Bank and Federal Reserve Bank stock.
Written equity options, which represent obligations rather than ownership.
Convertible debt or preferred stock that must be redeemed by the issuer or is redeemable at the investor’s option.

The Measurement Alternative for Nonmarketable Equity Securities

Many equity investments have no quoted price in an active market and do not qualify for the net asset value practical expedient. Shares in a privately held startup or a small community bank are common examples. For these, ASU 2016-01 offers a measurement alternative: carry the investment at cost, then adjust for impairment and for observable price changes from orderly transactions in identical or similar securities of the same issuer.¹ When a new funding round or a third-party sale provides a visible price signal, the entity updates its carrying amount.

The alternative is not an indefinite freeze at historical cost. At each reporting date, the entity performs a qualitative assessment to determine whether it is more likely than not that fair value has fallen below carrying amount.³ If it has, the entity writes the investment down to fair value and recognizes the loss in net income. Upward adjustments happen only when a real transaction provides evidence.

Impairment Indicators to Screen For

The qualitative screen looks at categories of red flags:

A significant decline in the investee’s earnings performance, credit rating, asset quality, or business outlook.
Major shifts in the investee’s regulatory environment, local economy, or relevant technology.
Significant adverse conditions in the geographic region or industry where the investee operates.
A bona fide purchase offer, a sale offer by the investee, or a completed auction involving the same or similar investment at a price below carrying amount.
Negative operating cash flows, working capital shortfalls, or noncompliance with debt covenants or statutory capital requirements.

If any of these indicators point toward impairment, the entity measures fair value and records the write-down through net income. The write-down cannot be reversed later if conditions improve.

Switching to Full Fair Value

An entity using the measurement alternative may irrevocably elect to move a particular security to full fair value measurement under ASC Topic 820 at any time. The election applies to that security and to all identical or similar investments of the same issuer going forward. There is no path back.

Own Credit Risk on Financial Liabilities

Before this update, entities that elected the fair value option for financial liabilities ran the entire change in fair value through net income. That produced a counterintuitive result: when a company’s own creditworthiness declined, the market value of its debt fell, generating a reported gain.

ASU 2016-01 changes the presentation. The portion of a liability’s fair value change attributable to instrument-specific credit risk now goes to other comprehensive income.¹ The remaining change, driven by factors like benchmark interest rate movements, continues to flow through net income.

When a fair-value-option liability is settled or extinguished before maturity, the accumulated other comprehensive income tied to own credit risk is reclassified to retained earnings. It is not recycled through net income.

For liabilities denominated in a foreign currency, the own-credit-risk change is first measured in the currency of denomination, then remeasured into the entity’s functional currency using end-of-period spot rates. The remaining fair value change follows the same remeasurement process.

Deferred Tax Assets on Available-for-Sale Debt Securities

The update also changed how entities assess the valuation allowance on deferred tax assets tied to unrealized losses on available-for-sale debt securities. That deferred tax asset must be evaluated in combination with the entity’s other deferred tax assets, rather than in isolation, when determining whether a valuation allowance is needed.¹ For entities holding substantial unrealized debt losses alongside other sources of taxable income, this combined analysis can produce a different allowance outcome than the segregated approach it replaces.

Presentation and Disclosure Changes

Financial assets and liabilities must be presented on the balance sheet separately by measurement category (fair value through net income, amortized cost, and so on) and by form (securities, loans, or other instruments).¹ That breakdown helps readers gauge the liquidity profile and risk characteristics of an entity’s holdings.

For investments carried under the measurement alternative, the notes must describe the nature of the observable price changes that triggered adjustments during the period. A reader should be able to trace why a cost-basis investment moved up or down and see what transaction supplied the evidence.

Fair Value Disclosure for Amortized-Cost Instruments

Public business entities must disclose the fair value of financial instruments carried at amortized cost using exit price measurements consistent with ASC Topic 820. Some entities previously used entry-price methods for these disclosures, which could produce different results. Entities that are not public business entities got a simpler outcome: the fair value disclosure requirement for financial instruments measured at amortized cost was eliminated entirely for them.

Effective Dates and Transition

Public business entities were required to adopt ASU 2016-01 for fiscal years beginning after December 15, 2017, including interim periods within those years. For most calendar-year public filers, that meant the 2018 fiscal year. Private companies, not-for-profit organizations, and employee benefit plans adopted a year later, for fiscal years beginning after December 15, 2018.¹

Transition generally follows a modified retrospective approach. An entity records a cumulative-effect adjustment to the opening balance of retained earnings in the fiscal year of adoption rather than restating prior periods.⁴ One exception: equity securities without a readily determinable fair value that are measured under the new measurement alternative follow a prospective transition method, so prior-period carrying amounts stay as they were and the new guidance applies going forward.

Clarifications in ASU 2018-03

In February 2018, the FASB issued ASU 2018-03 to address implementation questions raised during early adoption. The corrections were narrow but important for preparers:¹

When an observable transaction in a similar security triggers a measurement-alternative adjustment, the adjustment reflects fair value as of the date that transaction occurred, not the reporting date.
When an observable transaction occurs on the underlying equity security, the entire value of any related forward contracts or purchased options must be remeasured.
An entity using the measurement alternative may irrevocably switch to full fair value measurement under Topic 820. The election covers the specific security and all identical or similar investments from the same issuer.
The own-credit-risk presentation rules apply regardless of whether the fair value option was elected under the embedded derivatives guidance (ASC 815-15) or the general financial instruments guidance (ASC 825-10).
The own-credit-risk component of a foreign-currency-denominated liability is measured first in the currency of denomination and then remeasured into the reporting entity’s functional currency using end-of-period spot rates.

These corrections did not change the core requirements of ASU 2016-01. They resolved ambiguities that could have led to inconsistent application across entities during the transition period.

1
Financial Accounting Standards Board. ASU 2016-01 Financial Instruments Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities
2
Financial Accounting Standards Board. Summary of Statement No. 115 – Accounting for Certain Investments in Debt and Equity Securities
3
Financial Accounting Standards Board. Proposed ASU Financial Instruments Overall (Subtopic 825-10): Recognition and Measurement
4
Financial Accounting Standards Board. Proposed ASU Technical Corrections and Improvements to ASU 2016-01 and ASU 2016-02