A return to the past: disclosing market values of financial instruments.

All entities large and small, public and private, financial and nonfinancial must comply with FASB Statement no. 107.

The Financial Accounting Standards Board is battling to enhance the relevance of financial reporting for banks, savings and loans and other financial institutions. FASB Statement no. 107, Disclosures about Fair Value of Financial Instruments, issued in December 1991, targets financial instruments of all entities, but financial institutions will be most affected. The standard requires market value disclosure for virtually all financial instruments, broadly defined to include receivables and payables, forward contracts, options, guarantees and equity instruments. This pronouncement is part of a larger financial instruments project begun by the FASB in 1986.

The Statement no. 107 disclosure requirements apply to financial statements issued for fiscal years ending after December 15, 1992, except for entities with less than $150 million in total assets. For those entities, the statement is effective for fiscal years ending after December 15, 1995, to allow them sufficient time to develop the systems necessary for implementation.

A RETURN TO THE PAST?

Before 1938, banks reported market (also known as fair or current) values for financial instruments. A return to market value reporting is now occurring, driven by the S&L and banking crisis. Ironically, it was another financial disaster, the Great Depression, that fueled the 1938 conversion from market value to historical cost financial reporting.

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In the late 1920s and early 1930s, bank examiners were concerned primarily with protecting bank depositors (Federal Deposit Insurance Corp. protection did not exist). During this time, examiners determined market values for hank assets and liabilities to arrive at bank equity. If a bank's liabilities exceeded or even approximated its assets, its capital was determined to be impaired.

To satisfy regulatory capital requirements, problem bank owners had to provide additional capital, merge with another bank or close. At the onset of the Depression, bank examiners generally were blamed for excessive hank closings and the troubled economy. This set the stage for a series of bank conferences with regulators in 1938 at which bank asset appraisal procedures were relaxed.

RECENT ATTEMPTS TO USE MARKET VALUE

The controversy surrounding the valuation of financial instruments heated up again in the mid-1970s. The Securities and Exchange Commission and the American Institute of CPAs began the battle when they tried to establish market values for real estate investment trust debt by requiring realistic loan loss reserves. The FASB added to the dehate the question of whether restructured debt should be adjusted to reflect market values when interest payments are deferred or when interest rates are reduced. The end product, FASB Statement no. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, was much less restrictive than the original proposal.

The S&L industry provides another example of a successful drive to thwart market value accounting for financial instruments. Despite the Federal Home Loan Bank Board (FHLBB) chairman's belief that historical cost information fails to account for financial institutions' true performance, a task force that was commlssioned by the FHLBB in the early 1980s recommended against any broad use of market value accounting.

REQUIREMENTS OF FASB 107

A return to market value is now occurring. Statement no. 107 requires disclosure of "fair" value for virtually all financial instruments. (The FASB chose the term "fair" over "market" value to avoid the implication the statement applies only to items traded on active secondary markets.) The question of whether to actually recognize market value or historical cost on the balance sheet still is undecided; it will be decided in subsequent phases of the financial instruments project.

Detinition and scope. The FASB considers a financial instrument's market value to be the amount it could be exchanged for in a current transaction between willing parties, other than in a forced or liquidation sale. Financial instruments are defined as cash, evidence of an ownership interest in an entity or a contract that both

* Imposes on one entity a contractual obligation (1) to deliver cash or another financial instrument to a second entity or (2) to exchange financial instruments on potentially unfavorable terms with the second entity.

* Conveys to that second entity a contractual right (1) to receive cash or another financial instrument from the first entity or (2) to exchange other financial instruments on potentially favorable terms with the first entity.

In general, a financial instrument consists of cash, or a contractual obligation ending with the delivery of cash, or an ownership interest in an entity. Any number of obligations to deliver financial instruments can be links in a chain that qualifies a particular contract as a financial instrument.

Statement no. 107 applies to all entities, large and small, public and private, financial and nonfinancial. The FASB considered excluding predominantly nonfinancial institutions. It concluded, however, that even though the effect would be greatest on financial institutions, financial instruments also constitute a large portion of the assets and liabilities of some predominantly nonfinancial companies (for example, Ford Motor Credit, General Motors Acceptance Corporation, insurance companies, pension plans, brokers and securities dealers and so forth).

Unless specifically excluded, Statement no. 107 requires market value disclosures for all financial instruments even if they are not recognized in the statement of financial position. Specifically excluded are deferred compensation arrangements such as pension obligations and other postretirement benefits. Also excluded are

* Substantively extinguished debt.

* Most insurance contracts.

* Lease contracts.

* Warranty obligations.

* Unconditional purchase obligations.

* Investments accounted for under the equity method.

* Minority and equity investments in consolidated subsidiaries.

* An entity's own equity instruments. Generally accepted accounting principles already require disclosure or recognition of market value for many classes of financial instruments. Although the terminology, definitions and methods of estimating market value differ, the amounts computed to comply with previous pronouncements are acceptable for Statement no. 107. Exhibit 1, page 74, lists FASB, American Institute of CPAs and SEC pronouncements that already require market value or an acceptable surrogate of market value.

Disclosure requirements. If a financial instrument is publicly traded, disclosure of quoted market prices in the most active market provides the most reliable information. When quoted market prices are not available, an estimate of the market price should be used. For some financial instruments, such as short-term receivables and payables, market value may approximate historical cost due to the relatively short maturity. Similarly, adjustable loans that reprice frequently at market rates, such as variable-rate mortgages, also are likely to be carried at an amount approximating market value. In these situations, the disclosure requirement already is satisfied.

For longer term loans, the estimate should be based on the market prices of similar loans or other financial assets that have similar credit ratings, interest rates and maturity dates. Alternatively, market value estimates can be determined by discounting the instrument's expected cash flows at current market rates for financial instruments having similar maturities and risks.

Statement no. 107 says some financial instruments, such as interest rate swaps and foreign-currency contracts, are "customtailored" and may require a market value estimate based on the quoted market price of a similar financial instrument, adjusted as appropriate for the effects of tailoring. Some banks use option pricing models, such as Black-Scholes and binomial models, to support their estimates for foreign-currency options, put and call options on stock and options on interest rate contracts.

Market values for financial liabilities not publicly traded can generally be estimated using the same techniques for estimating the value of financial assets. The FASB provides an example in which a loan payable is valued at the discounted amount of future cash flows. The discount rate is based on either the entity's current incremental rate of borrowing for a similar liability or on the rate the entity could pay a creditworthy third party to assume its obligation.

In estimating the market value of deposit liabilities, the statement does not allow a financial entity to take into account the value of its long-term relationships with depositors, commonly described as core deposit intangibles. Core deposits are valuable because of the low interest rate required to maintain them. Statement no. 107 does not, however, prohibit the entity from disclosing an estimate of their value as an intangible asset.

Entities are required to disclose the methods and significant assumptions used to estimate financial instruments' market value. Where it is not practicable for an entity to estimate market value, information needed to estimate market value (carrying amount, interest rate and maturity) should be disclosed. Reasons why market value could not be determined also should be provided. In the context of the statement, "practicable" means an estimate of market value can be made without incurring excessive costs.

BASIS FOR FASB CONCLUSIONS

Reliance on historical cost information can have an adverse effect on internal management decision making. Financial institutions often are reluctant to sell assets whose market value is below book value. For example, S&Ls may be reluctant to foreclose on problem loans because' the repossessed real estate must be revalued at fair market value, often resulting in a loss. (While GAAP usually anticipates losses, the judgment involved in loan valuation makes unrealized losses avoidable.)

Conversely, management is more likely to sell assets that result in reporting a gain, for example, fixed-rate mortgages with above-market interest rates. Thus, management is not always encouraged tomake decisions that enhance the company's longterm economic value. The disclosure of market value information removes some of the incentives to distort income by disclosing unrealized gains and losses.

Among external users, bank regulators may be the primary beneficiaries of market value information for financial instruments. Troubled institutions will be identified much sooner (except in cases of fraud or sudden large reductions in asset values). Bank regulators can then step in, before economic insolvency, and minimize the cost to the FDIC.

The feasibility of disclosing market values has presented the greatest obstacle to implementation in the past. Fully aware of this problem, the FASB researched many controversial issues before it issued its pronouncement.

Internal studies. The FASB conducted eight field studies to evaluate how affected companies accumulate and report market values for financial instruments. They found many institutions already have systems in place to report, for internal purposes, estimated market values for financial instruments that are not traded.

The FASB considered 204 comment letters. Respondents were concerned about the standard's costliness, subjectivity and verifiability. The FASB, however, felt it had taken many steps to address these objections, and the additional relevance of the information the standard provided overshadowed the reliability issue. The FASB also considered the testimony of 19 respondents, including each of the six largest accounting firms. They generally were supportive of the pronouncement and confirmed financial instruments' market values are auditable.

External studies. The FASB asked the Bank Administration Institute (BAI) to conduct a study to identify the sources banks use to obtain market values for financial instruments. The survey results indicate markets exist for many types of securities, including high-quality commercial and industrial loans, loans to less-developed countries, mortgage-backed securities and asset-backed securities. Most financial instruments were valued at dealer prices, some were traded on an exchange and others required the use of mathematical models. Generally, models were used to supplement dealer prices in fairly inactive markets believed by the institution to be either underpriced or overpriced. (Exhibit 2, page 76, illustrates how banks currently estimate market values according to the BAI survey).

PLACEMENT OF MRKET VALUE DISCLOSURES

Market value information potentially can be displayed in several ways. It may be shown parenthetically on the face of the statement of financial position or it can be shown in the notes to the financial statements. One footnote alternative is to display all market value information required by Statement no. 107, and the market value information already required by existing pronouncements, in a single note that reproduces the main captions of the statement of financial position. Another alternative is to provide a supplemental statement of financial position in which all items for which market values are available are reported at those amounts. Exhibit 3, above, shows an example of Statement no. 107 disclosures.

The disclosure of market values for financial instruments is right for the times. Recently, the Treasury Department began advocating market value disclosure, the Office of Thrift Supervision began experimenting with an internally developed market value model and SEC Chairman Breeden made clear his preference for the use of market value accounting by financial institutions. But disclosure of market values is only an interim step. The FASB must now address the recognition and measurement of financial instruments on the balance sheet.

* FINANCIAL ACCOUNTING Standards Board Statement no. 107, Disclosures about Fair Value of Financial Instruments, requires all entities to disclose the market value of most financial instruments. The statement applies to financial statements issued after December 15, 1992, except for entities with less than $150 million in assets, which have a December 15, 1995 effective date.

* THE FASB CONSIDERS a financial instrument's market value to be the amount it could be exchanged for in a transaction between willing parties, other than in a forced or liquidation sale.

* GAAP ALREADY REQUIRES market value disclosure for some financial instruments. The amounts computed under previous pronouncements are acceptable for Statement no. 107.

* FOR A PUBLICLY TRADED financial instrument, the quoted market price in the most active market is the most reliable. Estimates should be used when no market price is available. In some cases, information from similar instruments is used to estimate market value.

* BANK REGULATORS WILL be the primary beneficiaries of market value disclosures. Troubled institutions will be easier to spot, and early intervention may prevent insolvency.

* MARKET VALUE INFORMATION can be shown parenthetically on the face of the statement of financial position or in the notes to the financial statements.